Battling investment bias

First, recognize the most common cognitive and emotional biases that exist, then work around them to make sound choices.

For two days last October, hundreds of people waited in line at Dundas Square in downtown Toronto, snaking toward a pastel-pink pop-up booth. Those with enough patience to queue for an hour or more were rewarded with ... a doughnut. Not just any doughnut, mind you, but a gourmet variety from a local doughnut “boutique,” beautifully packaged in a rose-coloured house-shaped box.

 

More importantly, the doughnut was free.

 

The giveaway — staged to promote the Google Home Mini, a doughnut-sized smart speaker that works with Google’s voice-activated assistant à la Apple’s Siri or Amazon’s Alexa — was a genius marketing move based on a simple human trait: we tend to grossly overvalue anything that’s free.

 

If, for example, you were to ask the recipients of those free doughnuts if they’d wait an hour in line for $3.50 in cash (what the event’s supplier, Jelly Modern Doughnuts, charges retail for the custom version of its sweet treats), it’s unlikely you’d have any takers.

 

Google capitalized even further on the emotional pull of free things by randomly placing a free Home Mini device, worth $79.99, in some of the boxes. For argument’s sake, let’s say you agree the possibility of getting $79.99 in cash is worth an hour of your time. What if, instead, you’re about to buy a $1,000 smartphone, and have “a chance” to save $79.99 if you line up for an hour. Would you do it? How about if you were buying a new car? Would you give up an hour for the possibility of saving just $79.99 on a 30K purchase?

 

According to traditional economic theory, we should place an identical value on a free doughnut worth $3.50 and on $3.50 in cash, and ought to consistently value the exchange of an hour of time for the possibility of saving $79.99, regardless of circumstances. But that’s not the way the human brain works.

 

“We’ll wait in line for free stuff, even if it doesn’t make sense,” says Ryan Decker, an economist and professor at North Central College in Naperville, Ill. “This is why we have behavioural economics. People don’t act rationally.”

 

University of Chicago professor Richard Thaler was among the first to observe and study such behavioural phenomena — proposing innovative concepts that helped earn him the 2017 Nobel Prize in economics. He and other pioneers of behavioural economics, including fellow Nobel laureates Daniel Kahneman (2002) and Robert Shiller (2013), have shown that most of us don’t act in accordance with supposedly “logical” economic theories, and often behave in ways counter to our interests.

 

“If we are going to have useful theories about how typical people shop, save for retirement, search for a job or cook dinner, those theories had better not assume that people behave as if they were experts,” writes Thaler in his 2015 book Misbehaving: The Making of Behavioral Economics. “We don’t play chess like a grandmaster, invest like Warren Buffett, or cook like an Iron Chef.”

 

Rather, people make predictable errors due to universal biases that influence behaviour, Thaler noted. Moreover, we can seek out methods to “hack” these biases and “nudge” us into making decisions that are more in line with our interests.

 

“There are two main ways to deal with these inherent biases,” says Decker, a former transfer pricing manager at PwC. “First, through education so we understand that we have these biases, and second by creating behavioural solutions so that we can use these biases to work for us.”

 

Lisa Kramer, a professor of finance at the University of Toronto’s department of management and a research fellow at Behavioural Economics in Action at Rotman, agrees. “This is how we behave as humans. We need to stop feeling guilty about things we do that are human nature and instead look at the ways we can use our human nature to better our situations.”

 

To that end, here are some of the most common behaviourial biases that we humans face, along with suggestions as to how you can make them work for, rather than against, you.

 

STATUS QUO BIAS (A.K.A. INERTIA)

As the laws of physics tell us, unless acted on by outside forces, an object at rest stays at rest and an object in motion stays in motion. The same can be said of our decision-making process. Humans prefer to maintain their current state, even if making a change would provide a better outcome.

 

Examples are everywhere, from the renewing mortgagee who stays with his or her current lender instead of searching out better rates; to the gym member who never works out but continues to pay monthly fees instead of cancelling the contract; to the procrastinator who plans to start saving for retirement soon but can’t seem to get started.

 

Understanding this human tendency to remain with the status quo, Thaler proposed an interesting solution to retirement savings procrastination. If employers with defined contribution pensions automatically enrolled their employees in the plan and provided a provision to opt out, rather than put the burden on the individual to opt in, inertia would work in the employee’s favour.

 

Thaler was right, as his and subsequent research studies have shown. A 2015 paper by Vanguard Research, for example, looked at half a million new hires from January 2010 to December 2012, and found that 91% of those under automatic enrolment remained in their employer plan after three years, compared with 42% under voluntary enrolment.

 

How to make it work for you

Even if your employer doesn’t automatically enrol you in its pension plan (or doesn’t offer a pension at all), there are lots of ways you can use inertia in your favour. For one, try not to sign up for open-ended gym or service contracts that involve monthly payments until you cancel; instead, insist on a specific term that requires you to take action when the contract expires. Set up automatic monthly transfers from your chequing account to a tax-free savings account or registered retirement savings plan. Or try out a service such as Mylo, an app that will automatically round up every purchase you make and invest the spare change. So, for example, if you spend $3.25 at Starbucks (using a credit or debit card that’s linked to the app), Mylo rounds up your purchase to $4 and sets aside 75¢ in your Mylo account. Every week, it adds all the roundups generated with your purchases, withdraws the total from your chequing account and invests it for you in a customized portfolio of low-fee exchange-traded funds (with management expense ratios of 0.05% to 0.37%).

 

LOSS AVERSION

It’s better to have loved and lost, romantics say. But according to behavioural economics, individuals feel the pain of losses much more acutely than they experience the pleasure of gains. Researchers Amos Tversky and Daniel Kahneman proved this bias against loss in 1991 using a coin-toss experiment. They found the average person would only agree to bet on the toss if the potential winnings were about double the potential losses — say, heads you win $20; tails you lose $10.

 

This is why during a market downturn, many investors sell off funds even though it breaks the first rule of investing: buy low, sell high. The pain of the loss is too much for them to handle. “They see their nest egg start to vanish and they panic with a knee-jerk reaction. Their instincts lead them astray,” says Kramer.

 

Indeed, some argue we’re hardwired to avoid losses at all costs because it gave us an evolutionary advantage. “In caveman times, you might die if you lost everything,” says Sekoul Krastev, cofounder and strategy director of The Decision Lab, a Montreal-based nonprofit that uses behavioural science to improve outcomes in the public and private sectors.

 

For similar reasons, we also tend to overvalue objects that we already own, what researchers call the endowment effect. We perceive money as being less “real” than objects, says Krastev. Once we’ve made a purchase and converted an abstract — money — into something tangible, we ascribe more value to it. “You own it, it’s yours and becomes part of your identity. But valuing something doesn’t necessarily mean you’ll enjoy it more,” he cautions. “People are generally bad at predicting what makes them happy.”

 

How to make it work for you

Once you’ve decided on a diversified investment portfolio that aligns with your risk tolerance and time horizons, tune out the daily market reports. “Turn down the volume, look away,” says Kramer. “If you’ve made a sensible allocation, there’s no reason to be looking at your portfolio frequently. Annually should be enough for most people.” And don’t shoot for unrealistic returns. “If you try to outperform the market, chasing funds that had good returns in the past, you can end up with a below-average rate of return,” she says. “Being an ‘average investor’ is better than giving in to all of these impulses.”

 

In terms of spending, paying cash triggers the pain of loss aversion to a greater extent than paying by credit, because you have to hand over the money (while the credit card is returned).

 

If you go cash-only for discretionary items, you’ll likely reduce your spending.

 

Finally, don’t agree to any free trials unless you’re sure you want to buy that product or service. Marketers count on the magic of loss aversion, which is why they offer you that 30-day money-back guarantee.

 

MENTAL ACCOUNTING

According to traditional economic theory, all money is fungible — or mutually interchangeable. But anyone who has splurged on a vacation after receiving a tax refund or bought a ridiculous outfit with a clothing-store gift card knows that we don’t treat all money equally. We rarely spend “found money” in the same manner we spend hard-earned funds, and we create all sorts of mental “rules” for money, depending on the circumstances.

 

For example, in a 1983 experiment Kahneman and Tversky came up with two hypothetical scenarios involving a $10 ticket to see a play, and asked participants what they would do. In the first case they posited, you bought a ticket ahead of time, but upon entering the theatre realize you lost it. In the second scenario, you didn’t buy a ticket in advance, but upon entering the theatre notice you lost a $10 bill. While both situations involve a loss of $10, just 46% were willing to buy another ticket in the first scenario because they felt as though the cost of admission had doubled, but 88% — nearly twice as many — said they would buy a ticket in the second case because they had not yet mentally allocated the lost $10 bill to the cost of seeing the play.

 

How to make it work for you

By putting savings into a separate account, you’ll reduce the temptation to spend it. Even better, open multiple savings accounts for various purposes — say, a vacation fund and an emergency fund — and have your tax refund or bonus automatically deposited in the latter. For discretionary spending, the classic jars or envelopes labelled for entertainment, take- out/restaurant meals, clothing, etc., can be effective. Once the cash you put in for the month is gone, you’ll be less likely to overspend what you budgeted.

 

SOCIAL NORM BIAS

Commonly known as keeping up with the Joneses, this bias prevents us from making independent decisions based on a solid cost-benefit analysis, and instead causes us to do whatever our peers are doing. Social norms can also explain the rationale behind any sudden buying trend — from Furbies to coconut water to the latest must-have tech stock.

 

The social norm effect is so strong that neighbours of lottery winners have higher-than-average bankruptcy rates, because they buy conspicuous assets such as cars and boats in an attempt to keep up. According to a Canadian study co-authored by University of Alberta business professor Barry Scholnick, for every $1,000 increase in lottery winnings, there’s a 2.4% increase in the number of bankruptcies for those who shared the winners’ postal codes — that is, their immediate neighbours — in the following two years.

 

Social media — and the so-called fear of missing out (FOMO) it breeds — has exacerbated the situation, according to a 2016 survey of 874 Canadians conducted by Ratehub.ca. A quarter of respondents say FOMO is their main motivation to shop, and 70% attribute up to a quarter of their debt to FOMO spending. Half of the millennials in the survey say they feel FOMO on social media, with the main culprits being Facebook and Instagram.

 

On the plus side, the UK tax agency used social-norms messaging to increase tax payments, as noted in a 2016 report by Deloitte and Prosper Canada entitled Insights to Impact: Harnessing Behavioural Science to Build Financial Well-Being. “They added a single sentence to their reminder notices that ‘9 out of 10 people in your postal code pay their tax on time’ and repayment rates jumped dramatically.”

 

How to make it work for you

In the same way Weight Watchers uses positive peer pressure to help dieters lose weight, joining a savings circle or investment club might take advantage of our collective yearning to follow the crowd. “In a savings circle, the group holds members accountable for setting specific savings goals and making small monthly savings contributions to achieve them,” states the Deloitte report. “By doing it in a social setting, there is more pressure to meet commitments, which leads to greater savings.”

 

To help counter the social media FOMO effect, consider unfollowing anyone who makes you feel irrationally jealous, and start following some reputable personal finance experts who share content that supports your goals.

 

HYPERBOLIC DISCOUNTING (A.K.A. MYOPIC BIAS, SHORT-TERM BIAS, PRESENT BIAS)

Our brains are wired to favour the present — which means we prefer to get something today over an even greater something tomorrow. Similarly, future costs aren’t felt as deeply as today’s costs. “This is not a bad thing on its own, but we tend to overdiscount the future,” says Decker.

 

For example, he cites research on conference participants who were asked to choose a snack: fruit or chocolate. When making the choice a week in advance, most (74%) chose fruit. But when selecting the snack for that day, 70% went for the chocolate. “When our current self doesn’t have to bear the cost, we make the smarter/healthier decision,” he says. (The cost in this case, of course, is forgoing the delectable chocolate.) “When we’re asked to bear that cost today, we’re less likely to do it. And this shows up throughout your life — as kids, young adults, etc.”

 

Thaler’s groundbreaking Save More Tomorrow (SMarT) program capitalized on this bias by having people make a commitment in the present to increase their savings rates in the future, when their salaries increased. The result? After almost three and a half years and four annual raises, average savings rates for SMarT program participants nearly quadrupled, to 13.6% from 3.5%.

 

How to make it work for you

As Thaler illustrated, creating shorter-term deadlines for longer-term goals is one way to get around present bias. “Take advantage of this attachment to money in the present and set up [savings/retirement plans] that automatically increase your contributions in the future,” says Kramer.

 

Another tactic is to try to better connect the concept of future self to current self, instead of viewing your aged counter-part as some alien third party. “We don’t feel close to our future self in retirement. So researchers speculated if we draw closer ties [to our future self] we might save more,” says Kramer. They were right on the money. People who were shown an age-progressed photo of themselves socked away more than twice as much for retirement as those who saw only a current undoctored photo.