An Introduction to Behavioural Finance
In this article, the first in a series on this topic, we look at an investment theory called behavioural finance.
We believe that understanding its key principles can help us all understand why, as private individuals, we sometimes make well-intentioned decisions that in hindsight appear to have been ill founded.
Behavioural finance is a branch of economics that tries to understand the psychological and behavioural factors which, alongside conventional economic theory, explain why investors act the way they do. It provides a framework that not only explains these behaviours, but aims to educate investors to help them make more informed decisions.
Here we look at the history of behavioural finance and some of its basic principles.
Why behavioural finance?
According to conventional investment theories, the price of an asset – such as a share or a bond or a property – is based on rational foundations (or ‘fundamentals’). These include the financial health and performance of a company or an economy. It assumes that people are able to separate their emotions from their decision making.
It holds that given the same level of information investors will make the same choices in a way that aims to maximise their returns and minimise their risks.
However, in practice we often see that this is not the case, and investors can make unexpected, even seemingly irrational decisions. Consider how many people purchase lottery tickets in the hopes of winning a big jackpot. Logically, it does not make any sense when according to the National Lottery website, the odds of winning the top prize in the Lotto draw are approximately 1 in 45 million. But in spite of this, millions of people do it.
Behavioural finance theorists point to investment “bubbles” as primary evidence that market prices can be affected by the irrational behaviour of investors. They cite the Dutch tulip bulb mania of the 1630s, the South Sea Bubble of the 1710s, the junk bond crash of the 1980s, the ‘dot.com’ Internet stock bubble of the 1990s, as examples of how investors can get caught up in the enthusiasm for something new and exciting. More recently the value of one Bitcoin rose to nearly $20,000 in late 2017 but had fallen to around $3,000 less than a year later.
Followers of behavioural finance believe that this is because individuals have limits to their self-control and are influenced by their personal biases. They propose psychology-based theories to explain stock market anomalies, such as these severe rises and/or falls in asset prices.
Here are three more examples that illustrate how the actions of investors appear to go against perceived wisdom.
The January effect
Conventional thinking predicts that investment returns should be a ‘random walk’ with no predictable pattern. And yet it has been observed that in the US between 1904 and 1974, smaller companies returned 3.5% in January and roughly 0.5% in every other month*. This phenomenon puzzles academics to this day.
To behavioural finance, this ‘January effect’ is simple to explain. The US tax year follows the calendar year, and the January rise in share prices is down to investors taking advantage of bargains after retail investors realise losses to offset capital gains made elsewhere.
The winner’s curse
This is a tendency for the winning bid in an auction to exceed the ‘fair’ value of the item purchased. For example the sale price of a US home is regularly 25% or more above the professional valuation if it is sold in a ‘sealed bids’ auction, where all prospective purchasers provide their full and final offers at the same time.
This flies in the face of the assumption that investors are rational enough to assess the true value of an asset and bid or pay accordingly.
But to behavioural finance this is a prime example of fear or missing out: there is limited availability or a limited window to acquire an item, and desirability for this property outweighs its useful as a property.
The equity premium puzzle
This is one of the most confounding anomalies to conventional financial theory. The theory states that investors holding riskier financial assets should be compensated with higher rates of return. Over a period of more than 100 years, the difference between equity and bond returns that investors have demanded to compensate them for the higher risks of holding equities has been about 6% per year. So far so good.
However, conventional economic analysis suggests that it should be much lower, and the real-world results are a major puzzle to academics.
But a major discovery of behavioural finance is that people’s attitudes and feelings to losses and gains are not symmetrical. In fact, investors are twice as sensitive to losses as they are to gains. In other words, losing £100 feels twice as ‘bad’ as gaining £100 feels ‘good’. Or gaining £200 evokes the same level of feeling as losing £100.
As equity prices are more variable than bond prices over the shorter term, behavioural finance suggests investors are looking for higher levels of compensation than the basic facts expect.
An historical perspective
Surprisingly, behavioural finance is nothing new. Back in 1759, in The Theory of Moral Sentiments, Adam Smith (the founding father of economics) wrote that investors are just like everyone else: they make decisions on imprecise ideas and beliefs rather than rational analysis. He also went on to say that the way a question or problem is presented will influence the decisions people make.
*Source: Rozeff and Kinney Capital Market Seasonality: The Case of Stock Returns, 1976.
January’s Stock Temptation, Stephen J Ciccone, The Journal of Behavioral Finance, 2011
These two observations largely explain market inefficiencies; it’s because people are not mathematical equations.
But the rational “efficient markets hypothesis” (EMH) has come to dominate financial theory. This states that asset prices fully reflect all available information, and changes in price reflect the effects of all relevant information as it is released.
A direct implication is that it is impossible to achieve better returns than an index consistently (or "beat the market") since prices should only move in reaction to new information. Information that is available to everyone, everywhere, and at the same moment in time.
Indeed securities exchanges such as the London Stock Exchange and the New York Securities and Exchange Commission, have enacted regulations to control how a company releases information that could have an effect on its share price.
These aim to ensure a level playing field for all investors and should make it even harder to “beat the market”.
And yet active investors – those who try to perform better than the benchmark – still demonstrate marked variations in performance.
It was not until the late 1960s that the topic was revisited by Daniel Kahneman and Amos Tversky. They have published about 200 works focussing on how various psychological concepts that seek to explain how and why individuals engage in financial behaviour that is both irrational and unanticipated.
But it is only recently that behavioural finance has moved from academia into the mainstream.
What does behavioural finance tell us?
Students of behavioural finance believe that emotion and deeply ingrained biases influence our decisions more than we consciously recognise, and this makes it hard for us to act truly rationally.
They believe that investment decisions are influenced by two primary biases called cognitive errors and emotional preferences
These describe how people think. They result from the false memories and/or an inability to analyse information correctly, both of which can lead to faulty reasoning. It describes a large group of behaviours but in essence, there are two types of cognitive error: belief perseverance and information processing errors.
Belief perseverance is our natural resistance to modifying our beliefs when faced with new information that contradicts something we have previously held to be true.
Information processing biases are errors in reasoning when processing information related to a financial decision.
These are the result of factual reasoning over-ruled by feelings. Emotions often overpower our thinking during times of stress. We have all made irrational decisions at some time in our lives and this is frequently worse when we are put under pressure.
We will explore these topics in more detail in future briefings.
Critics of behavioural finance
Behavioural finance is not without its critics. Eugene Fama the founder of EMH suggests that even though there are some anomalies for which modern financial theory cannot account, EMH remains the best model for explaining and predicting economies, and should not be totally abandoned.
He believes that many of the anomalies inherent in conventional theories could be shorter-term random events which correct themselves over time. He has argued that many elements of behavioural finance seem to contradict one another. All in all, he argues, behavioural finance itself may be no more than a collection of anomalies, the sum of which can actually be explained by EMH.
The biggest critique of behavioural finance is that it is more of a philosophy than an actual science, since there are few, if any, controlled experiments to verify cause to effect.
Conventional economic theory assumes that everyone behaves rationally when making an important decision such as investing their wealth.
It is based on six guiding principles:
- Markets are efficient
- Investors are rational
- Investors don’t make errors of reasoning
- Investors have perfect self-control
- Decisions are based on usefulness
- Differences in expected returns are determined only by differences in expected risk
However, behavioural finance suggests the observed facts cannot support this hypothesis and counters that:
- Markets are not efficient
- Investors are biased
- Investors make human errors
- Investors have limited self-control
- Decisions are based on desirability
- Differences in expected returns are determined by differences in the fear of experienced risk
As in all active debates there are supporters on both sides of the argument. But investors are increasingly discussing and using the insights of behavioural finance to improve they ways in which they use EMH to make investment decisions.
“Know thyself” was inscribed above the entrance to the Temple of Apollo at Delphi, and the tenets of behavioural finance can help us all understand our motivations and weaknesses a little better.
Followers of behavioural finance believe that this can perhaps help us make better – or at least more rational – decisions.
A bubble is the rapid expansion in the price of an investment that strongly exceeds its true value. It can also describe a situation where asset prices appear to be based on implausible or inconsistent views about the future.
Because it is often difficult to observe true values in real time, bubbles are generally identified in retrospect, once a sudden drop in prices has occurred. Such a drop is known as a crash or a bubble burst.
Junk bond is a pejorative term for some forms of high-yield bond. These bonds have a higher risk of default. They therefore typically have higher potential returns than better quality bonds to make them more attractive to investors.
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