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Behavioural finance: failures of reasoning

Conventional economic theory (known as the efficient market hypothesis) assumes that everyone behaves rationally when making an important decision such as investing their wealth. However, behavioural finance practitioners counter that the observed facts do not support this hypothesis.

They point to investment bubbles and market crashes, as evidence that individuals are not mechanical, and that we are all influenced by our historical experiences and expectations.

In this, the third in our occasional series, we will look in more detail at the reasons why we might not be as objective in analysing data as we might think we are and why we can distort or misinterpret the facts. This leads to errors in processing information and false reasoning.

Behavioural finance calls these biases cognitive failures.

What do we mean by cognitive failures?

There are two main approaches to decision making:

  • Reflexive or ‘gut reactions’, which is effortless, automatic and our hard-wired default option.
  • Reflective or ‘second thoughts’ which is logical and methodical, but requires effort to engage actively.

The efficient markets hypothesis assumes that investors are perfectly rational and reflective. Behavioural finance theory counters that humans are imperfectly irrational, and tend towards reflexive decision making.

Behavioural finance recognises many ways in which false reasoning (or “cognitive biases”) are expressed through our actions, but they can be distilled into five key actions:

  • herding and bounded rationality,
  • frame dependence and anchoring,
  • representative bias and the gambler’s fallacy,
  • narrow framing, the narrative fallacy, and mental accounting,
  • over-reacting and availability bias

We will look more closely at each of these in turn.

Herding and bounded rationality

This is the tendency to mimic the financial behaviours of the majority, or ‘herd’, either in place of or in spite of our own independent and thorough critical analysis. Herding is often considered the biggest explanation behind dramatic share price rallies and crashes.

This is because we intuitively believe that the majority “can’t all be wrong” and “they must know something I don’t”. Herding can become more prevalent in areas where we have little experience or expertise.

There is also a strong human imperative to be accepted by a group and to be part of a crowd, and it is closely linked to our inability to make rational decisions under emotional strains, such as anxiety, anger, or excitement.

The key thing is that we are hard-wired to herd. Indeed, psychologists have discovered that going against the crowd actually causes physical pain similar to having your arm broken.

It can certainly trigger fear, especially a fear of missing out.

  • The dot.com bubble of the late 1990s is a prime example of herd mentality. Huge amounts of money were invested in internet companies, even though very few of those companies had sound business models.
  • The reassurance received from seeing so many other investors do the same thing made people feel comfortable, confident and validated.

Herding can lead us to buying at or close to the top, just in time to watch the share price fall in value. Investors who are easily swayed by the herd also tend to buy and sell investments frequently as they chase the latest investment trends. However, this can incur substantial transaction costs, reducing the potential for long-term profits.

There is a very practical limitation to our abilities as private investors. We can only make decisions based on the limited knowledge we can accumulate. There are thousands of stocks to choose from but we have neither the time nor the desire to research each and every one of them. So instead of making the most efficient decision, we frequently have to settle for making the most satisfactory decision.

You might see this described as ‘bounded rationality’ or ‘limited attention span’. Because of this restriction, private investors tend to focus on stocks that come to their attention through websites, financial media, social media, friends and family.

  • If a pharmaceutical stock gains approval for a blockbuster drug, an increase in the share price could be magnified because the reported news catches the eye of thousands of investors.
  • Smaller news about the same stock might not reach the media and, therefore, only professional investors may be aware that the investment case has changed, leading to a minor change to the share price.

Frame dependence and anchoring

Frame dependence describes the way in which we make decisions based on how information is presented to us, rather than unpicking the facts and making an objective choice.

The same facts presented in two different ways can lead to very different outcomes or decisions; for example by focusing on the potential loss or potential gain of an investment choice.

We are particularly open to being influenced by framing when we are not sure of all the facts or where a number of unknowns are involved.

Compare the following statements:

  • In Q3, our earnings per share were £1.25, compared to our guidance of £1.27.
  • In Q3, our earnings per share were £1.25, compared to Q2 when they were £1.21.

Both may be true, but the second option frames the information in a more positive light. Anchoring is a form of framing dependence in which we rely too heavily on pre-existing information, or a previously provided data point.

  • For example, if we see a T-shirt priced at £1,200 then see a second one that costs £100, our first response is that the second shirt is cheap (relative to the anchor) when under other circumstances we would think it was expensive.

If asked to estimate where you think Apple’s stock, will be in three months, how would you approach it?

Fundamentals

In business and economics, fundamentals represent the basic qualities and reported information needed to analyse the health and stability of the economy, business or investment in question.

Many people would take today’s share price and then make assumptions about where it’s going to be in three months? That’s a form of anchoring: building our sense of future value based on the anchor of today’s value.

A better approach would be to understand Apple’s revenue streams, product development cycle, competitors, and key markets. Will Apple as a company be bigger and/or more profitable? How much more? What will that be worth then? How does that future potential compare to other opportunities? What are we prepared to pay for that today?

Investors buying shares that have dropped considerably in value over a short span of time are guilty of anchoring their idea of the share’s true value on the recently achieved high.

They believe that this could be an opportunity to buy the stock at a discounted rate. And this could be true.

  • However the share price could have fallen due to a change in its fundamentals. Such as the entire board resigning, or the company on the brink of being prosecuted for serious breaches of international law.

The degree to which we cling to our anchors is heavily determined by how relevant the anchor is, and how easy or difficult it is to reach an independent assessment of the ‘right’ price to pay. The problem with anchors is they don’t necessarily reflect intrinsic value and we can come to focus on the anchor as our foundation.

Representative bias and the gambler's fallacy

Representativeness is the extrapolation of future results based on a limited set of observations or facts. When the superficial similarity of objects is confused with the probability of an outcome, it can lead us to incorrectly believe that two events are more closely related than they are. This is a common information processing error.

In financial markets, one example of this representative bias is automatically assuming that good companies make good investments, or that future results can be based on historical performance. Just because a company has seen high growth for the past five years doesn’t mean this is going to continue for the next five or ten years.

Similar to this is the ‘gamblers fallacy’: the erroneous belief that a particular random event is more or less likely to happen following another event or a series of events.

  • If we flip a coin 20 times in a row and it lands ‘heads’ side up every time, the gambler’s fallacy would predict the next flip is more likely to land tails side up. If it has landed with heads up so many times, it must be about time for the other outcome to occur, correct?
  • Well, no. The likelihood of a normal coin turning up heads or tails is always 50%.
  • Because each flip of the coin is an independent event, all previous flips have no bearing on future flips no matter how unusual their outcomes.

In investing the gambler’s fallacy manifests itself when investors sell their shares in a company if they have gone up in value over several trading sessions because the position is unlikely to continue to increase. Conversely, some investors might hold on to a stock that has fallen for several consecutive session because it seems like it is “time” for the stock price to pick up.

Intrinsic value

Intrinsic value usually refers to the ‘core’ value of a company, share, currency or other product determined through original analysis, and without reference to its current market value.

It is usually calculated by forecasting and summing all the investment’s future potential income and then calculating what that is worth today allowing for inflation.

Narrow framing, narrative fallacy and mental accounting

Narrow framing is the evaluation of too few factors that may affect an investment. For instance, an investor may buy a security because of its past performance without considering economic factors that could change the company’s performance.

People love stories and we can sometimes let our love of a good story get in the way of our objectivity. It can draw us towards less desirable outcomes simply because of the story. And this is an example of narrow framing known as the narrative fallacy.

Why do we love stories? Because, stories have emotional content, which makes them very easy to remember, and which appeals to our subconscious or reflexive reasoning.

It is one reason why investors are more interested in shares than they are in bonds: companies can have great stories. The most admired stocks often have the greatest stories, but they also have the highest prices. Bonds are more technical and do not generally have ‘good stories’.

Mental accounting is a specific kind of narrow framing in which different investments are mentally segregated, applying different subjective criteria and due diligence to each account, even where this different treatment may be unwarranted.

  • For example, treating separate investments as if they were the only investment rather than as part of a larger portfolio.

This line of thinking can be highly illogical.

Many people keep a special “money jar” or similar fund set to aside money for a vacation or a new home while at the same time carrying substantial credit card debt.

  • It is totally illogical to maintain a savings jar that earns little or no interest while simultaneously holding cred-card debt accruing double-digit interest annually.

This compartmentalised approach to managing wealth can lead us to think that money in this special fund is somehow different to the rest of our financial arrangements.

In this example it can lead us to diverting funds from debt repayment, which in turn can lead to increased interest payments thereby reducing our total net worth.

We can also treat money differently depending upon its source. ‘Found’ money, such as tax refunds and gifts, tends to be spent more freely than our regular salary.

But logic suggests they should be treated in the same way.

Overreaction and availability bias

The concept of market efficiency assumes that new information about an investment will be reflected more or less instantaneously in its price. Good news about a company should increase the business’s share price a proportional amount, and that price should then remain steady until new information about the company becomes available.

In reality, though, this idealised expectation rarely happens in such a simple fashion. Instead, investors frequently overreact to new information, creating an impact which is larger than it should be relative to the nature of the information. However, this surge in value is rarely permanent but fades over time, even if no new information has been introduced.

This latter feature is known as the availability bias: the tendency to overstate the effect of recent events because the memory is fresh, and new opinions become biased toward the latest news.

Availability bias can creep into our lives in subtle ways as well as significant ones.

  • Imagine you see a car accident along a stretch of road that you drive on regularly.

It is likely that you’ll become more cautious on that stretch of road, at least for a few days after the accident, even though the level of danger has not changed; seeing the accident caused you to overreact.

  • But over time, it’s likely that you’ll regress to your previous driving habits.

In a 1985 study*, Werner De Bondt and Richard Thaler analysed the historical three-year performance of shares listed on the New York Stock Exchange and created a portfolio of the top 35 ‘winners’ and portfolio of the bottom 35 ‘losers’.

  • They traced these portfolios for the next three years to see what would happen. They discovered that the losers’ portfolio actually beat the index consistently while the winner’s portfolio consistently underperformed the index. At the end of the three-year period, the cumulative difference between the two portfolios was nearly 25%.

They theorised that in the three years leading up to the start of the experiment investors had tended to overreact. For losing stocks this led to the stocks’ share prices falling disproportionately low.

Over time, and as it became clear that this pessimism was exaggerated, the losing stocks began to regain their values as investors realised that the stocks were under-priced. The same is true in reverse for the winners’ portfolio, as investors eventually understood that their initial enthusiasm was overblown.

Conclusion

According to behavioural finance false reasoning prevents us from acting rationally. Whether it’s unnecessary anchoring, availability bias or simply following the herd, chances are we’ve all been guilty of at least some of these behaviours.

*Source: De Bondt and Thaler, “Does the Market Overreact?”, Journal of Finance, 1985.

If you saw something of yourself in this article, understand that the best way to avoid the pitfalls of reflexive reasoning is to have a reasoned investment strategy and to stick to it. Misinformation and decision-making errors probably account for most market inefficiencies, because no one can know everything and, even if they did, they may not make the best decisions based on that information.

However, fore-warned is fore-armed and being aware of these all-too-human tendencies can help us become more objective when investing.

To do this we should aim to exercise reflective reasoning, and use a rigorous approach to focus on the process rather than the outcomes.

If we miss opportunities to learn from our past miscalculations we are likely to miscalculate again, renewing a cycle of anxiety, discomfort, dissonance, and denial. We should also remember that even with the best reasoning skills, investment outcomes cannot be guaranteed.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at April 2019 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, number 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.

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