Canadian Investment Review

Acting Up: Behavioural Finance

Written by Scot Blythe on Thursday, November 4th, 2010 at 11:25 am

broken eggsAs a speaker at this month’s Investment Innovation Conference in Arizona (November 30 – December 2), Steve Foerster, professor of finance at the Ivey School of Business at the University of Western Ontario will be sharing his views on how precepts from behavioural finance can better influence investment decision-making. In advance of the conference, we asked him to answer questions on the development and application of behavioural finance. To find out more about Steve’s presentation and the Investment Innovation Conference, click here.

Q: Why spotlight behavioural finance?

A: Behavioural finance is an important area because much of what has been taught in financial theory for decades has been based on some very simplistic assumptions in terms of the way that individuals behave. In particular, it has assumed that investors are always rational. And yet the real world suggests that that is not true.

Q: How does behavioural finance replace traditional theory?

A: It doesn’t replace it. It complements it in that it tries to explain some empirical observations that suggest investors are not always rational. The ideas behind behavioural finance go back decades and originated in studies in the psychology area. Psychologists were examining how individuals make decisions in general and more recently the ideas have been applied to how investors make decisions.

Q: How successful has behavioural finance been in complementing traditional theory?

A: I think the best example is how we could apply a lot of the behavioural finance concepts to explaining some of the behaviour that led to the financial crisis. If I can talk about U.S. real estate market as an example, which many have pointed to as the prime suspect in terms of the origination of much of the financial crisis, up until 2006, house prices in the U.S. in general, and in certain areas in particular, had been increasing on a regular basis and in some cases fairly dramatically.

So, many individuals felt that given that prices had been going up, then most certainly house prices would continue to go up. That led them to buy into houses even though they might have been borrowing up to 100% of the value of the house – even in some cases where their income was suspect. Lenders allowed this to happen because it really didn’t matter about the individual’s ability to repay – so long as house prices went up, then they could always sell the house for a higher price. So these are some key examples of behavioural biases, including excessive optimism and overconfidence.

Q: How would you use that in investment decision-making?

A: What one needs to do, certainly, is to do a reality check and look for ways to avoid these biases – such as to look more broadly in terms of framing decisions and basically looking for contrary opinions that might challenge your current thinking. For example, what might be the contrary scenario and how might it unfold?

To learn more about the Investment Innovation Conference, visit the events section of the website. If you are interested in attending the event, please email Garth Thomas to be considered, as limited space available.

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