How behavioural economics help us understand investors’ reactions to hybrid securities
ASIC commissioned the Queensland Behavioural Economics Group to undertake a research study into how behavioural biases influence individual investor’s preferences towards hybrid securities when compared to less complex financial products like bonds and shares. QBEG undertook the pilot study because ASIC was worried that some retail investors do not fully understand the complexity of hybrid securities and the risks they pose.
Behavioural economic research tends to demonstrate that many decisions, including investment decisions, are skewed by cognitive biases rather than rational consideration alone. The objective of the pilot study was to identify any behavioural biases that might affect allocation to hybrid securities within an overall investment portfolio and assess how the perceived risk of hybrid securities compares with shares and bonds.
The study results
The pilot study used techniques developed in behavioural economics, which places participants in a simulated environment in an experimental laboratory. The findings of the pilot demonstrated participant’s perceptions of the risk of different investment types.
Illusion of control
When subject to illusion of control bias, investors can feel that they can exert control over their environment and influence the outcomes. Allocation to hybrids increased by nearly 14% for participants who demonstrated the illusion of control bias. The presence of illusion of control implies that investors may think that they will have the ability to control risks involved in hybrid securities, for example by withdrawing ‘in time’ from an investment.
Overconfidence
When subject to overconfidence, investors may have a misguided sense of their own ability to withdraw from an investment early and consequently be protected from risk. The average allocation to hybrids was higher by more than 10% for participants with overconfidence bias. Overconfidence relates to unwarranted belief in one’s cognitive abilities, intuition, and judgment. Overconfidence could lead to portfolio under-diversification i.e. holding concentrated positions in a few hybrid securities. Overconfidence may tend to make investors underestimate downside risk and perceive hybrids to be safer investments than they actually are.