Overview

Traditionally, advisors and academics minimize irrational human behaviour when theorizing the approaches to use when determining the ‘optimal’ amount of risk someone should take. However, this has proven to be costly to some who have followed; if someone takes more risk than they can emotionally handle (even if they technically can afford to), it may cause them to panic in market downturn and lock in all of their portfolio losses.

At Qube, we believe in respecting the ‘human’ side of investing. We mitigate these risks by creating open and trusting relationships with our clients. A part of doing so is getting to know our client’s behavioural investor types (BITs) and tailoring our approach accordingly.

Reflect back for a moment on the decisions you’ve made in life and how they have impacted your journey. Were they rational? Were they free from external influence?

Why Does This Matter?

Market volatility has the ability to make even the most seasoned investors anxious. It is important to understand how attitudes, emotions, and biases can influence investor decision-making. Individuals who understand their behavioural biases can construct portfolios that are better suited to mitigate panicked decision making when markets undergo fluctuations.

Regardless of an individual’s actual capacity to take on risk, risk tolerance needs to be incorporated into the risk decision. Risk capacity and tolerance can work in tandem but also against one another. For example, an investor may have a high-risk capacity (more wealth than required, guaranteed pension, etc.), but if risk causes them emotional distress or feelings of extreme insecurity, then being in a higher risk portfolio can actually cause them harm. There is a trade-off that exists between increasing risk exposure for a higher potential gain and the risk of panicked decision-making that accompanies it.

What Are The Behavioural Investor Types?

BITs (developed by Michael Pompian, CFA, CFP) were designed to assist advisors in making swift and insightful assessments of what type of investor their clients are before constructing an investment plan. We have taken his work and expanded on it, creating an approach that is easier to understand and apply to everyday life.

Each BIT is classified using an investor’s risk tolerance level as well as the types of biases that they display—whether it be emotional bias (driven by impulses, attitudes, or feelings) or cognitive error (driven by faulty reasoning).

The first step in understanding your Behavioural Investor Type is to classify yourself as an active or passive investor. In general terms, active investors have generated their wealth by risking their own capital. An example of this is an entrepreneur who invested their savings into a company that became successful. Inherently, they have high risk tolerance relative to a passive investor who may have accumulated wealth through less risky measures like employment income or inheritance.

What are ‘Cognitive Errors’ & ‘Emotional Biases’?

Framing bias, for example, occurs when individuals make a decision based on the way that information is presented, as opposed to focusing on the facts themselves. Suppose we create the following experiment:

The way the experiment above is constructed results in the same outcome—if you land on heads, you end up with zero and if you land on tails, you end up with $50. As such, the payoff (and risk) is the same in both cases. However, the first group is framed to believe that the coin toss is a risky gain, while the second group sees the coin toss as a risky loss. As a result, the majority of individuals will agree to the first gamble and reject the second gamble.

Emotional biases arise as a result of attitudes or feelings that cause an individual’s decision to deviate from rationality. These biases are usually ingrained in the psychology of investors and can generally be more difficult to overcome than cognitive biases. Emotional biases can look like an extreme aversion to losses (loss aversion), unwillingness to change a current investment approach (status quo bias), or the need to compartmentalize different savings goals into different accounts (mental accounting).

Overconfidence bias, for example, often leads individuals to overestimate their understanding of financial markets and disregard correction or professional advice. This can present as believing that it is possible to consistently beat the market by making risky bets or by overestimating one’s own capacity for risk. It can lead to poor portfolio performance or investment strategies that are misaligned with needs and goals.

As an investor, it is crucial to study your investment decisions thoroughly. Self-awareness of existing biases paired with a review of your decisions can help you avoid these errors to some extent. Individuals who are better in-tune with their emotions, feelings, or biased attitudes tend to make more rational decisions.

A Brief Dive into the BITs

Ganymedes are active investors with medium to high risk tolerance, a growth investment style, and are primarily exposed to cognitive errors. These individuals are critical, analytical, and independent thinkers who do their own research and have original ideas about the investment world. Ganymedes understand that risky assets can, and will, go down, but will rarely admit that the drop might be due to their own mistakes. Ganymedes tend to enjoy investing and collaborating with financial advisors.

Understanding your Behavioural Investor Type and how cognitive errors and emotional biases impact the construction of your portfolio are complex and important financial topics. Individuals who aspire to enhance their understanding of behavioural finance techniques or are seeking professional investment management will benefit from the services of a Portfolio Manager.

DISCLAIMER

Qube Investment Management Inc. has authored the material presented above for the promotion of financial literacy and professional development. Qube makes no warranty for the accuracy, validity, or completeness of the above information. It is not intended to provide specific advice with respect to individual financial, investment, tax, legal or accounting matters.

 For advice specific to your situation, consult an appropriate investment, legal or accounting professionals.

Overview

We all have vastly different sentiments when it comes to saving, investing, and taking on risk.

Traditionally, advisors and academics minimize irrational human behaviour when theorizing the approaches to use when determining the “optimal” amount of risk someone should take. However, this has proven to be costly to some who have followed; if someone takes more risk than they can emotionally handle (even if they technically can afford to), it may cause them to panic in market downturn and lock in all of their portfolio losses.

At Qube, we believe in respecting the “human” side of investing. We mitigate these risks by creating open and trusting relationships with our clients. A part of doing so is getting to know our client’s behavioural investor types (BITs) and tailoring our approach accordingly.

Reflect back for a moment on the decisions you’ve made in life and how they have impacted your journey. Were they rational? Were they free from external influence?

Traditional finance assumes that all investors are Rational Economic People (REP) who maximize return and wealth for a certain (optimal) amount of risk. In the simplest form, traditional finance holds the assumption that all individuals are rational human beings. This approach attempts to predict how investors should behave; that is, people behave in a predictable manner free of any cognitive errors or emotional biases.

On the other hand, behavioural finance is rooted in reality: individuals do not behave under the assumptions of traditional finance. Rather, this relatively new academic discipline seeks to explain not what investors are predicted to do, but what they actually do. Charitable giving, setting up an RESP for the grandkids, and GoFundMe Campaigns, among others, all would not exist if traditional financial theory held true. Simply put, we all possess goals that contradict wealth maximization and are subject to decision-making errors and biases.

Why Does This Matter?

Market volatility has the ability to make even the most seasoned investors anxious. It is important to understand how attitudes, emotions, and biases can influence investor decision-making. Individuals who understand their behavioural biases can construct portfolios that are better suited to mitigate panicked decision making when markets undergo fluctuations.

Regardless of an individual’s actual capacity to take on risk, risk tolerance needs to be incorporated into the risk decision. Risk capacity and tolerance can work in tandem but also against one another. For example, an investor may have a high-risk capacity (more wealth than required, guaranteed pension, etc.), but if risk causes them emotional distress or feelings of extreme insecurity, then being in a higher risk portfolio can actually cause them harm. There is a trade-off that exists between increasing risk exposure for a higher potential gain and the risk of panicked decision-making that accompanies it.

What Are The Behavioural Investor Types?

BITs (developed by Michael Pompian, CFA, CFP) were designed to assist advisors in making swift and insightful assessments of what type of investor their clients are before constructing an investment plan. We have taken his work and expanded on it, creating an approach that is easier to understand and apply to everyday life.

Each BIT is classified using an investor’s risk tolerance level as well as the types of biases that they display—whether it be emotional bias (driven by impulses, attitudes, or feelings) or cognitive error (driven by faulty reasoning).

The first step in understanding your Behavioural Investor Type is to classify yourself as an active or passive investor. In general terms, active investors have generated their wealth by risking their own capital. An example of this is an entrepreneur who invested their savings into a company that became successful. Inherently, they have high risk tolerance relative to a passive investor who may have accumulated wealth through less risky measures like employment income or inheritance.

Once we have determined whether an individual is an active or passive investor, the next step is to scan for cognitive and behavioural biases.

What are “Cognitive Errors” & “Emotional Biases”?

Cognitive errors are basic statistical, information processing, or memory errors that cause an individual’s decision to deviate from rationality. These are errors are due to faulty reasoning like rules of thumb, decision-making without all relevant information, or trusting the crowd over doing analysis. Unlike emotional biases, they can be resolved by education and proper financial advisement. Simply identifying an individual’s errors and improving their financial literacy can prove effective in alleviating the harmful impact of flawed decision making.

Framing bias, for example, occurs when individuals make a decision based on the way that information is presented, as opposed to focusing on the facts themselves. Suppose we create the following experiment:

The way the experiment above is constructed results in the same outcome—if you land on heads, you end up with zero and if you land on tails, you end up with $50. As such, the payoff (and risk) is the same in both cases. However, the first group is framed to believe that the coin toss is a risky gain, while the second group sees the coin toss as a risky loss. As a result, the majority of individuals will agree to the first gamble and reject the second gamble.

Emotional biases arise as a result of attitudes or feelings that cause an individual’s decision to deviate from rationality. These biases are usually ingrained in the psychology of investors and can generally be more difficult to overcome than cognitive biases. Emotional biases can look like an extreme aversion to losses (loss aversion), unwillingness to change a current investment approach (status quo bias), or the need to compartmentalize different savings goals into different accounts (mental accounting).

Overconfidence bias, for example, often leads individuals to overestimate their understanding of financial markets and disregard correction or professional advice. This can present as believing that it is possible to consistently beat the market by making risky bets or by overestimating one’s own capacity for risk. It can lead to poor portfolio performance or investment strategies that are misaligned with needs and goals.

As an investor, it is crucial to study your investment decisions thoroughly. Self-awareness of existing biases paired with a review of your decisions can help you avoid these errors to some extent. Individuals who are better in-tune with their emotions, feelings, or biased attitudes tend to make more rational decisions.

A Brief Dive into the BITs

Gloucesters are passive investors with low risk tolerance, conservative investment style, and primary exposure to emotional biases. These individuals value financial security and preserving wealth rather than taking risks to grow wealth. Gloucesters are guardians of their assets and therefore take losses very seriously. Who makes up this group of individuals? Older investors often behave in ways more aligned with these traits. It is not uncommon for Gloucesters to focus their wealth on ensuring that their family and future generations are financially secure by funding their education or purchasing a home.

Caiuses are investors with medium risk tolerance, a moderate investment style, and are primarily exposed to cognitive errors. These passive investors tend to follow the opinions of others rather than have their own ideas about investing. Caiuses often lack interest in and/or have little aptitude for investing. In fact, these individuals can often trick themselves into believing that they are talented in the investment realm when a single decision ends up working in their favour, which can lead to risk seeking behaviour such as taking part in the latest investment fad at a time when prices are already peaking.

Ganymedes are active investors with medium to high risk tolerance, a growth investment style, and are primarily exposed to cognitive errors. These individuals are critical, analytical, and independent thinkers who do their own research and have original ideas about the investment world. Ganymedes understand that risky assets can, and will, go down, but will rarely admit that the drop might be due to their own mistakes. Ganymedes tend to enjoy investing and collaborating with financial advisors.

Pyramuses are active investors with a high-risk tolerance, an aggressive growth investment style, and are primarily exposed to emotional biases. They are interested in maximizing wealth and are often confident that they will achieve their goals. These individuals tend to overestimate their quality of judgement when it comes to investing. This can lead to high portfolio turnover (with decreased investment performance) due to rushed decision-making. Pyramuses want to steer the ship, and this often makes it challenging for them to follow the advice of financial professionals.

Understanding your Behavioural Investor Type and how cognitive errors and emotional biases impact the construction of your portfolio are complex and important financial topics. Individuals who aspire to enhance their understanding of behavioural finance techniques or are seeking professional investment management will benefit from the services of a Portfolio Manager.

DISCLAIMER

Qube Investment Management Inc. has authored the material presented above for the promotion of financial literacy and professional development. Qube makes no warranty for the accuracy, validity, or completeness of the above information. It is not intended to provide specific advice with respect to individual financial, investment, tax, legal or accounting matters.

 For advice specific to your situation, consult an appropriate investment, legal or accounting professionals.