The underlying factors that influence investment decisions may have more to do with DNA and culture than previously thought, Grace Yulu writes.
As an investor, what role does your gender, age, personality, religion and culture play on the investment decisions you make?
According to Behavioural Finance Australia, it is now widely accepted that investors are influenced by a range of psychological factors when making decisions, these include cognitive, emotional, neurological, perceptual and social factors, which then influence their investment decision making capabilities that leads to either substantial wealth creation or wealth destruction.
The 2014 report 'Quantitative Analysis of Investor Behavior’, found that over a 20-year period investors earned an average of 5.02 per cent per annum while the S&P 500 index returned an average of 9.22 per cent per annum over the same period. The reason for the variance in earnings was due to investors’ tendency to sell after markets had fallen and buy when the markets had already risen substantially. Quite simply, they were driven by irrational factors.
The most common five investment biases (irrational behaviours) exhibited by investors include holding onto beloved shares and not wanting to sell due to a preconceived notion that there will be a major comeback and eventually selling right at the bottom of the market, buying familiar shares e.g. those that are hyped by the media, making buy decisions based on past performance figures, not diversifying appropriately or sufficiently and trading excessively.
In an effort to understand what caused investors to make these errors in judgment, why some investors were less prone to these irrationalities and if it was possible to temper such behaviour, economists Henrik Cronqvist and Stephan Siegel addressed this in their paper 'the genetics of investment biases’ and observed that up to 45 per cent of investment decisions are due to genetics.
Though genetic effects play an important part in how one behaves, they should not be the determining factor of one’s fate. Genetic predispositions can be moderated by understanding the link between investors’ decision making, genetics, and their past experiences. For the purpose of this discussion, genetic make-up will be considered to be composed of an investor’s personality, gender, age, culture and religious influences (i.e. demographics and socio-economical factors).
I am of the belief that it is imperative that financial advisers should take a client’s genetic make-up into account before providing them with personal advice as this does inadvertently play a role in how they act (especially in volatile market conditions) and the investment decisions they make.
Personality, age and gender
Personality captures a person’s essence. Understanding one’s personality helps explain and predict the decisions an individual makes and what a person will do. Personality traits are a major aspect of risk taking and overconfidence behaviours. Understanding personality can improve decision making if it helps to regulate and override dispositional tendencies leading to suboptimal outcomes. (Fung, Lucia and Durand, Robert B, 2014) Personality researchers have proposed that there are five basic dimensions of personality.
The Five-Factor model is the principal structural model of personality. This model summarises all personalities into five broad traits or dimensions: openness, conscientiousness, extraversion, agreeableness, and neuroticism. These five traits are universal. This is based on studies undertaken in other languages, which have shown that similar personality traits do emerge in many languages and cultures.
Ascertaining what an individual’s personality is can be complex and complicated as people do tend to display behaviours across several of these personality traits. It is imperative that advisers in an effort to understand their clients and as part of the “know your client” procedure, learn to identify their clients’ personality types.
These “personality profiles” can then be used to help structure investment portfolios that actually meet the clients’ expected returns and mitigate any surprise behaviours from the clients during extreme market movements. Additionally, this may even work at establishing a closer adviser-client relationship.
Research undertaken on the effect of gender differences on investor behaviour has had varied results with the predominant outcomes, establishing that there are significant differences in the way men and women invest, with women being more risk averse than men. Women are thought to have a more severe reaction to negative outcomes, leading to greater risk aversion, than men. By contrast, men are more likely to feel anger while females feel fear thus making them less likely to take risky gambles.
These outcomes have been found to be dependent on level of income, education, whether the participants are single or married, etc. For example married men are found to be more conservative than their single counterparts.
On the whole, both male and female investors decrease their risky asset allocation with age as prescribed by many investing rules of thumb.
It is important for advisers to be aware of these gender biases and use this knowledge to offset their client’s in-built traits, thus minimising any negative impulses that could hinder the client’s wealth accumulation efforts. For example, it is a common fact that women tend to live longer than men; yet research has shown that women tend to be more risk averse (predominantly invest in low-risk/low return assets), which then translates to having less to live on in their retirement years.
Culture and religion
Culture is the “collective programming of the mind” and “distinguishes the members of one human group from another” (Hofstede, 1980). Culture is often subconscious. The 'iceberg model’ of culture asserts that values (invisible) influence behaviours (visible) (Selfridge and Sokolik, 1975; Hall, 1977).
According to Meir Statman, people are affected by their cultures and experiences. Although it is tempting to say that people are the same everywhere, the collective set of common experiences that people of the same culture share will influence their cognitive and emotional approach to investing.
In 'Does Culture Affect Economic Outcomes?’ Guiso, Sapienza, and Zingales (2006) defined culture as “those customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation”. Culture matters and it is persistent. A lesson from these studies is that financial advisers should also consider their client’s culture and religious background as they influence their individual investment choices. The relevance of culture and religions is immediately evident in Islamic banking and finance, making Islam the most fascinating religion for academics in the finance field. The investment decisions of individuals that adhere to the Islamic religion are bound to be influenced by Sharia.
Sharia- which regulates many aspects of a Muslim’s life including the type of investments allowed – forbids Muslims from paying or receiving interest (riba) as it is considered as extortion and is unjust. This could then be expected to affect the financial decisions of Muslims, including the instruments they choose to invest in.
This ban is seldom enforced by nations, highlighted by the fact that individuals looking to invest do have the flexibility to utilise the conventional banking systems and associated debt instruments or alternatively opt to select a Sharia compliant bank and invest in Sukuk – Islamic debt securities that are structured to comply with Sharia.
Lastly, socially responsible investing can be seen as an offshoot borne of investor’s religious, moral and ethical beliefs or values that are extoled differently by different people. For example, some investors may have a different take to investing in funds that have exposure to companies that derive income from gambling, tobacco or alcohol while other investors would pick funds based on their positive environmental impact, such as green companies.
Conclusion
The preceding research has shown that it is important to pay attention to the “silent” or “underlying” factors that influence an individual’s genetic make-up (including demographic and socio-economic factors) as they have been found to predispose investors to behave in certain ways that could ultimately be detrimental to their long term wealth accumulation and retention plans.
An individual’s genetic composition is an important determinant of the individual’s investment behaviour.
A better understanding of these genetic factors that underlie individual differences that give rise to these behavioural anomalies will be beneficial to all. Once people identify what their “irrational triggers” are, they then have the opportunity to ensure that these triggers are tempered, and the most economically sound decisions are made. Though it may seem time consuming and invasive to clients, my belief is that in order to build a strong client-adviser relationship and to be able to manage risk and return expectations, “investor DNA profiling” should be undertaken as part of the fact find and risk profiling process. This would entail clients answering a list of questions designed to capture the factors that influence their genetic make-up. The results can then be used as a guide in structuring the most appropriate investment portfolio.
Grace Yulu is research analyst with Suncorp Life.
