Hello and happy spring to you all. Extra daylight, buds on the trees, a turning of the soil in the gardens, and soon we will finally get rid of sweaters. Spring symbolizes new beginnings. If you’re looking for a sign to start fresh, this season is all you need.

With the first quarter of 2023 now in the books, we now look back on what occurred in the markets and use it to help guide us going forward. Arguably, the biggest events last quarter was the slowing of interest rate hikes from Central banks, the collapse of Silicon Valley Bank, and the steepening of the yield curve following its inversion. We hope that our biweekly wrap-ups have sufficiently covered these events, so we thought to take a different approach with our quarterly newsletter. With an opportunity to share information in a longer- format, this allows us the chance to do more of a deep dive on one subject.

Behavioural Finance – Do You Have a Behavioural Bias?

The human mind is our most powerful organ that we have, and the most powerful instrument in the universe (save for AI, but that discussion can be for another day). It’s what allows us to do all the wonderful things that we have in our lives, and it is arguably the biggest reason you have an investment portfolio. How we construct an investment portfolio is based on a large set of data that was analyzed, and with that, decisions were made, and bonds and stocks were picked out and purchased. We then monitor this and make decisions based on changes which happen in the world.

Navigating the markets is not an exact science, and an element of art is often required when making investment decisions. For example, an investor might think that stock XYZ is overvalued because its market capitalization exceeds the sum of all its competitors. On the flip side, another investor might say that stock XYZ is undervalued because of its ability to disrupt the industry. At times, these views could be subject to behavioural biases which in turn could lead to suboptimal investment decisions. This is, at its core, the single largest detractor from an investor achieving their investment objectives and goals. Behavioural biases can be divided into two categories: cognitive and emotional. We’d like to spend a few a few minutes to highlight common cognitive biases, the potential consequences, and the strategies that we can all use to mitigate suboptimal outcomes.

Cognitive Biases:

Cognitive biases are typically driven by a combination of an individuals’ personal beliefs and/or irrationality when it comes to processing information. The good news is that these biases can often be corrected through better information, education, and advice.

Scenario: Phil and Claire have been married for 23 years and have one son, Luke. They both work at a real estate development company and would describe themselves as having an average risk tolerance and a long- time horizon. The bulk of their wealth is held within registered accounts (RRSP’s and TFSA’s) which are maxed every year, and they keep the balance of cash in a high-interest savings account. They’ve been happy with the performance of their investment returns, with a particular emphasis on the strength and stability of their Financial holdings. At the same time, they’ve been hearing talks about a pending recession and the risks to the financial system. However, they are comforted when one of their friends tells them, “The banks lend to everyone, and are too big to fail”. Soon after, one of their close friends convinces them that they need to minimize their market exposure because companies will likely go bankrupt just like in the Great Financial Crisis. Their child, Luke, also mentioned that Canadian households are highly indebted and that they should have some exposure to bitcoin to diversify away from the Canadian dollar. Phil and Claire are not familiar with bitcoin, but their recent portfolio returns have been better than expected and therefore would be comfortable allocation their gains into bitcoin. They also noticed that their REIT’s have underperformed due to higher interest rates but as real estate developers, they know this sector will rebound because Canadians have a strong attachment to real estate and therefore have decided to double down.

Phil & Claire might be subject to the following cognitive biases:

Confirmation bias: A tendency to overweight information that supports existing thought processes/beliefs and to undervalue information that come off as contradictory.

• Consequence: Phil and Claire are concerned about the pending recession and its potential impact to their Financial exposure. However, they choose to place a larger emphasis on their colleague’s opinion that the banks are “too big to fail”.
• Mitigation: Confirmation bias can be corrected/reduced by actively seeking information that challenges existing thought processes. For instance, an analysis could be done to determine the reserve levels of the banks versus potential loan losses.

Framing bias: An information processing bias in which a response/interpretation is skewed due to how it was framed.

• Consequence: They were convinced that the next recession could result in a similar market sell-off, like the GFC in 2008. The risk is that they might not be making an apples-to-apples comparison.
• Mitigation: Framing bias can be corrected/reduced by asking more specific questions. For instances, “The 2008 crisis was driven by elevated housing risks and poor lending practices. Is this the same scenario today?”

Mental accounting: A bias that may lead to suboptimal investment decisions because money is mentally segregated between different “buckets” even though money is fungable.

• Consequence: Phil and Claire have no experience with crypto but they believe having some exposure makes sense given the recommendation from their son. Furthermore, they appear to have a lower attachment to this investment because the capital is funded from recent gains. Even if bitcoin doesn’t work out, they’re okay taking a loss because it wasn’t their money to begin with.
• Mitigation: Recognize that money is fungible whether the capital was earned through employment income or capital gains. Once that capital is earned, it becomes a component of their net worth and should be utilized in a manner that aligns with their financial goals and objectives.

Representative bias: A tendency to extrapolate from past experiences/outcomes when processing new information.

• Consequence: Phil and Claire’s REIT holdings have underperformed but based on personal experience, investors have historically benefitted from buying the dip in every pullback in recent memory. Therefore, they are not concerned with their exposure.
• Mitigation: Representative bias can be corrected/reduced by analyzing a larger sample size and determining if there are nuances between time periods (e.g., change in interest rates). For example, one could compare historical affordability rates, accounting for average home prices and income levels across various time periods.

Gambler’s fallacy: A bias in which an individual believes a future outcome is more or less likely due to past outcomes.

• Consequence: Phil and Claire’s decision to double down on their REIT holdings might be biased because of the robust growth in real estate prices within recent years. Furthermore, they might believe they have an edge given that they both work in the industry.
• Mitigation: Gambler’s fallacy bias can be corrected/reduced by recognizing that events are typically independent from one another. Phil and Claire should recognize that the macroeconomic environment and consumer behaviors have shifted meaningfully in a short period of time. For instance, hybrid/remote work is likely structural in nature and therefore the prospects for office REITs will likely be negatively impacted on go-forward basis.

In sum, cognitive biases are inherent flaws in human thinking that can cause us to make inaccurate judgments and decisions. As investors, it can be difficult to separate one’s behaviours from logical and judicious decision making, but by becoming aware of these biases and taking steps to mitigate their effects, we can improve our decision-making skills and increase our chances of making sound and effective choices. 

Throughout our everyday practice of managing your wealth, we keep careful eye on all these cognitive biases. We are also keenly aware of emotional investing bias as well, but we’ll spare you that discussion for another letter.

For those still reading, yours truly graduated post-secondary school having majored in Psychology. At the time, I did not fully anticipate how some of the tools and skills learned there would directly relate to how I support you. I also appreciate that my own personal strengths are not met without equal (if not larger) weaknesses, and is a big reason why we have a team of people that work together. I truly believe that when constructed properly, a team is stronger together than the sum of their parts and is why I feel so confident in what we do for our clients. 

On behalf of all of us, thank you for the opportunity to support you and your family. 

Sincerely,
Jonathan Somerville