Financial Habits and BehaviourTalk

Institute for Financial Literacy

A collaboration between MoneySense, the national financial education programme, and Singapore

Polytechnic Enterprise.

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programmes for the public.

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Disclaimer

This session aims to help you evaluate information. It will not involve any advice on product selection.

Any mention of industries and companies, or reference to products, is solely for illustration and application of concepts.

You should consult a licensed financial advisor before making a decision to invest in any product.

ObjectivesUnderstand why we take mental shortcuts in our thinking and decision making

Explain how behavioural biases affect personal financial planning behaviour

Explain how to mitigate the effects of mental short cuts in our personal financial planning

Understand why we take mental shortcuts in our thinking and decision making

Working of our Brain

• Our brain is structured to take mental short cuts when we encounter complex activities such as managing our personal finances.

• Our brain cannot handle and analyze the volume of information bombarding us every moment and has to take mental short cuts

• These mental short cuts will result in decision making based on partial information or behavioural biases.

Impact of Behavioral Biases

• Ingrained financial habits relating to how we process information to reach decisions and the preferences we have when making choices we all assume that we are rational in our financial decision making

• May serve us well in certain circumstances or sabotage us in most other circumstances such as leading us to unhelpful or painful decisionns in our investments.

Are we rational or irrational?

One Common Assumption made by us…We are rational when dealing with money-related decision making.

BUT• Researchers find that we are not

rational and our “non-rational” behaviour falls into patterns and is somewhat predictable

• We make mistakes that are systemic and repeat them again and again

• We can learn to recognise our mistaken assumption and make plans to overcome or avoid it.

Explain how behavioural biases affect personal financial planning behaviour

The 3 Broad Behavioural Biases are…

Emotional Behavioral Biases• Decision making is based on

whether we feel comfortable rather than on what is right;

• We tend to over-estimate our abilities and believe we can correctly predict our chances of success;

Information Processing Biases• We make a decision first and then

find reasons to justify that decision;

Group Behavioral Biases• We flock together for security and

reassurance.

Types of Behavioral Biases and their ImpactImpact on individuals when managing their personal finances

Emotional

Overconfidence

Loss Aversion

Disposition

Regret

Information Processing

Framing

Mental Accounting

Anchoring

Group

Herding

Types of Emotional Biases and their

Impact

Overconfidence

• We tend to over-estimate our abilities and believe we can correctly predict our chances of success;

• Often, we have an unreasonable belief that good things will happen to us and bad things will happen to others.

Be Honest…

Think of two numbers:

What is the amount of money you are going to have when you retire? How big do you think your nest egg will be?How much do you think that an average person in your neighborhood will have when they retire?

• Is your number roughly twice as much as what you thought others in your neighborhood will have? We are overconfident and tend to overestimate our needs.

Characteristics of Overconfident Investors

• Believing they can consistently “beat the market”

• Making frequent trades – especially with a discount or on-line brokerage

• Not knowing their personal rate of return

• Believing that “investing in what they know” or familiarity is a guarantee of success

• Experiencing 2 other side-effects of Disposition and Regret

Overcoming Overconfidence

• Ask Can what I believe be false? Do I really know something

that others don’t?Whether I am fooling myself?

• Find An opinion contrary to yours

and think about it.

• Write Reasons why you can be

wrong.• Discount

Your expected return by reducing it by 25%.

Loss Aversion

Attitude towards loss • Disproportion between pleasure of gains and pain of losses.

• People tend to be loss averse and feel the pain of losses about 2 to 2 ½ times as strongly as they feel pleasure from gains.

Loss Aversion

If I flip a coin and offer you the following bet:• heads you pay me $100

• tails I pay you X amountHow much would I need to pay you for you to take the bet?

The mathematically correct and rational answer would be $100 because it’s a 50-50 bet. However, most people would want to be paid $200 - $300 to take the bet.

Characteristics of Loss Averse Investors

• Taking money out of the stock market when prices fall

• Selling winning investments more readily than losing investments

• Choosing only government bonds and avoiding stocks

• Leaving money sitting in cash and not wanting to invest it – even when the market stabilizes

Overcoming Loss Aversion

• Focuson Long Term performance

instead of Short-term volatility.• Plan

a diversified portfolio.• Track

returns less frequently.

The Disposition Effect

• Individuals tend to sell winners and hold losers, leading to a lowering of overall returns.

• By selling an investment at a gain, it becomes a winner, and the investor experiences the pleasure associated with a “good” investment.

• By hanging on to the losers, an investor can defer the pain associated with incurring a loss and can indulge in the belief or hope that the investment may bounce back and become another winner.

Regret

• Arises when an individual perceives a bad outcome from a decision that they made in the past.

• Usually there is more regret associated with taking an action that turns out poorly than with inertia or not taking an action that would have benefited us.

• Inertia means that people fail to get around to taking action or procrastinate, often even on things they want or have.

Case Study

• John owns shares of Company A. He considers selling his shares and buying stock of Company B but decides not to sell. He now finds he would have been better off by $20,000 if he had sold his stock in Company A, and bought the stock of Company B.

• Mary owns shares in Company B, but sells them and with the proceeds buys stock in Company A. She now finds she would have been better off by $20,000 if she had kept her shares of Company B.

• Who is more upset, John or Mary?

Mary would be more upset. Do you feel the same way?

Explain how to mitigate the effects of mental shortcuts in our personal financial planning

Types of Info Processing Biases and

their Impact

Types of Behavioral Biases and their ImpactWhat Impact individuals in managing their personal finances?

Emotional

Overconfidence

Loss Aversion

Disposition

Regret

Information Processing

Framing

Mental Accounting

Anchoring

Group

Herding

Framing

• “Narrow framing” refers to the tendency to make decisions using relatively narrow frames of reference.

• People tend to lose sight of the big picture and focus on the particular issue in front of them at that time.

Think about it for a minute…

Would you bet where you had a 50% chance to win $15,000 and a 50% chance to lose $10,000?

From a purely statistical point of view this is a favorable bet, but most people would reject it because they want a chance to win at least twice what they might lose.

Mental Accounting

• Our psychological self tend to think separate the money and risk of our wealth into individual buckets or ‘mental accounts.’

• This divert our focus to the individual buckets rather than thinking broadly, in terms of our entire wealth position.

Anchoring

• Creates artificial points of reference.

• Affects our judgments about things and our frame of reference.

• These points of reference may or may not apply to the decisions we are trying to make, but they have an impact anyway.

• Some anchors you may have control over, and some you don’t, but they can all affect how you see the world.

Examples of How Anchors can Impact Investors

• People are affected by the STI’s performance (a benchmark of performance of the top 30 blue chips, companies that are listed in Singapore stock market).

• Affected by benchmarks that they read in performance reports and newsletters they receive.

• Conversations with friends who brag about a great stock pick also create anchors.

Types of Group Biases and their Impact

Types of Behavioral Biases and their ImpactWhat Impact individuals in managing their personal finances?

Emotional

Overconfidence

Loss Aversion

Disposition

Regret

Information Processing

Framing

Mental Accounting

Anchoring

Group

Herding

Group Behaviour

• How this and other biases affect decisions made by groups.

• A group situation may counteract a particular bias or it may strengthen it.

• Equally, the group situation could create new biases.

Herding

• Refers to investors’ tendency to behave in a manner consistent with the larger group.

• Affects the way investors react to a market crash or rally.

• Mutual funds that receive 4- or 5-star ratings from Morningstar receive a hugely disproportionate flow of assets despite the fact that star ratings have repeatedly been shown to have had very little predictive value.

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Key Takeaways

• Humans are prone to decision-making using the X-system, and this is often unchecked by the more logical C-system.

• Emotional behavioral biases are based on whether we feel comfortable rather than on what is right.

• Information processing biases are based on making a decision first and finding reasons to justify it.

• Group behavioral biases show that people like to flock together for security and reassurance.

Useful Links

The MoneySense-Singapore Polytechnic EnterpriseInstitute for Financial Literacy:

https://ifl.org.sg(for details on programmes, e-learning)

MoneySense:www.moneysense.gov.sg

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