In this new series of posts we are going to look at how understanding behavioural finance can help you make better investment decisions and the process starts with getting a good grip on your financial personality. The key is to try becoming aware of the decisions you make and how you are likely to react to the uncertainty that comes with investing in the stock market. Understanding your financial personality can also help to control the irrational and illogical elements of your investment decisions.
Human nature usually serves us well in coping with day-to-day life. But it can also get in the way of achieving success in long-term activities, such as saving and investing. There is no cure for human nature, but in this series we’ll look at how greater awareness of investment psychology can help you avoid major pitfalls.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
Behavioural finance = investment psychology
According to accepted financial theory, human beings are rational (of sound mind). However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case. Dozens of examples of irrational behaviour and repeated errors of judgment have been documented. The late Peter L. Bernstein wrote in ‘Against The Gods’ that the evidence ‘reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty’.
The academic field of finance has long had a behavioural side. One of the classic examinations of irrational investor behaviour, ‘Extraordinary Popular Delusions and the Madness of Crowds’, dates back to the 19th century. In the 1930s, legendary economist John Maynard Keynes and value-investing guru Benjamin Graham spoke of the effect of investors' emotions on stock prices. More recently, in 1982, money manager David Dreman published ‘The New Contrarian Investment Strategy’, which argued that investors could outperform by not following market fads.
Modern portfolio theory is nonsense
The financial principles based on Modern Portfolio Theory (MPT) 1 and the Capital Asset Pricing Model (CAPM)2 have long shaped the way in which many investors judge investment performance.
The theory is based on the belief that investors act rationally and consider all available information in the decision-making process and as a result, investment markets are efficient and have factored all available information into the prices of investments. However, researchers have uncovered a surprisingly large amount of evidence of irrationality and repeated errors of judgement.
A field of behavioural finance has evolved that attempts to better understand and explain how emotions influence investors and their decision-making process. Daniel Kahneman, Amos Tversky, Hersh Shefrin, Meir Statman, Robert Shiller and Andrei Shleifer are among the leading researchers who have used theories of psychology to shine some light on the accuracy of financial markets, and explain stock market bubbles and crashes.
1 Markowitz, 1952.
2 Sharpe, 1964.
People frequently behave irrationally
One of the most basic assumptions that accepted finance makes is that people are rational. According to conventional finance, emotions and other factors do not influence people when it comes to making financial choices.
But the fact is, people frequently behave irrationally. For example, consider how many people purchase lottery tickets in the hope of hitting the jackpot. From a purely logical standpoint, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder (roughly 1 in 14 million for the National Lottery jackpot). Despite this, millions of people in the UK buy tickets week in, week out.
Anomalies
Despite strong evidence that the stock market is highly efficient, there have been scores of studies that have documented long-term historical anomalies (irregularities) in the stock market that seem to go against the efficient market hypothesis. While the existence of irregularities is generally well accepted, the question of whether you can use them to earn impressive returns in the future is subject to debate. Let’s now look at an example of one such anomaly; the winners curse.
The winner's curse
One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of an asset and will bid or pay accordingly. However, anomalies such as the winner's curse – a tendency for the winning bid in an auction to be higher than the true value of the item purchased – suggest that this is not the case. Rational-based theories assume that all people involved in the bidding process at an auction will have access to all of the relevant information and will all come to the same valuation.
Any differences in the pricing would suggest that some other factor, not directly tied to the asset, is affecting the bidding. According to Robert Thaler's 1988 article on the winner’s curse, there are two primary factors that weaken the rational bidding process: the number of bidders and the aggressiveness of the bidding.
For example, the more bidders involved in the process means that you have to bid more aggressively in order to put others off from bidding. Unfortunately, increasing your aggressiveness will also increase the likelihood that your winning bid will exceed the value of the asset.
Anchoring
Just as a house should be built upon a good, solid foundation, our ideas and opinions should also be based on correct facts in order to be considered valid. However, this is not always so. Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes and causes individuals to cling to a belief that may or may not be true, and to base their decisions for the future on that belief.
The inactivity that this leads to can have negative effects on their retirement accounts. For instance, if people anchor themselves to the belief that the stock market will keep going up, they will not only suffer from inactivity, they’ll be putting themselves at risk when the market eventually turns.
A diamond anchor
Consider this classic example taken from Investopedia.com: Conventional wisdom states that a diamond engagement ring should cost around two months worth of salary. This standard is a wonderful example of anchoring and illustrates why most of us make illogical and irrational financial decisions. While spending two months worth of salary can serve as a benchmark, it is a completely irrelevant reference point created by the jewellery industry to maximize profits, and not a valuation of love.
Many men can't afford to set aside two months’ salary towards an engagement ring while paying for living expenses. Consequently, a large number go into debt in order to meet the standard. In many cases, the diamond anchor will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt.
Although the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two-month standard. Because buying jewellery is an unusual experience for many men, they are more likely to purchase something that is around the standard, despite the expense. This is the power of anchoring.
In the next post in this series we'll go on to look at other common mistakes investors make.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
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3 Internal estimation taken January 1st 2015 of total ISA and pension assets owned by the ISACO Investment Team and ISACO premium clients.4 December 31st 1997 - December 31st 2014 ISACO 105.5%, FTSE 100 27.6%.
5 December 31st 2011 – December 31st 2014.
ISACO investment performance verified by Independent Executives Ltd.
