Key Concept of BEHAVIOURAL FINANCE
By Raju Uprety
Though all the models, theories and frameworks of Investment Management are logical as they are developed by veterans of the field after a series of repeated discussions and research, history has shown us that all market dynamics cannot be explained only with the existing models, theories or framework. When the share price of Standard Chartered Bank Nepal Ltd. reached around Rs. 7,000 that was not justified by any of these existing models, theories or framework. This is also true with the prices of the shares of many Nepali commercial banks. Nepal Stock Exchange and Securities Board of Nepal repeatedly issued notice warning investors on this. However, this did not have any significant effect on the behaviour of the investors.
Then what explains this anomaly? The answer lies on one basic assumption on which all the theories of Investment Management are based. All these theories assume that the investors for the most part are rational wealth maximisers. However, there are many instances where emotion and psychology influence the investor’s decisions, causing the investor to behave in unpredictable or irrational ways.
This unpredictable and irrational behaviour of an investor is explained by a relatively new discipline called Behavioural Finance.
Behavioural Finance seeks to combine the theories of behavioural and cognitive psychology with the theories of conventional finance to provide explanations to the people’s irrational financial decisions. (Phung, 2007). Behavioural Finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. (Sewell, 2007)
Here are a few concepts that are identified as contributing factors to irrational financial decisions.
Anchoring
The concept of anchoring draws on the tendency to attach our thought to a reference point even though such reference point may have no logical relevance to the decision at hand. For example, some investors invest in the stocks of companies that have fallen considerably in a very short time. In this case, the investor is anchoring on a recent height that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount.
Mental Accounting
Mental accounting refers to the tendency for the people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. For example, some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the possible negative returns from speculative investments from affecting the entire portfolio. The problem with such a practice is that despite all the work and money that the investors spends to separate the portfolio, his net wealth will be no different even if he had held single large portfolio.
Confirmation Bias
It is difficult to encounter someone who does not have a preconceived opinion. It is difficult to discard such opinion from his/her mind because people also tend to selectively filter and pay more attention to information that supports their opinions ignoring the rest. This type of selective thinking is often referred to as the confirmation bias. The confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seeking out information that contradicts it.
Gambler’s Fallacy
In most instances, an individual erroneously believes that the beginning of a certain random event is less likely to happen following an event or a series of events. This is known as gambler’s fallacy. For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don’t believe that the position is likely to continue to go up.
Herd Behaviour
Herd behaviour is the tendency for individuals to mimic the actions of a larger group. However, individually most people would not necessarily make the same choice. Reasons for herd behaviour are social pressure of conformity and common rationale that it’s unlikely that such a large group could be wrong. For example, investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. All frequent buying and selling incur a substantial amount of transaction costs, which can eat up all available profits. Furthermore, it is extremely difficult to time trades correctly to ensure that investor is entering the position when the trend is starting.
Overconfidence
Generally people are overconfident about their abilities. In terms of investing, overconfidence can be detrimental to stock picking ability in the long run. Researches have constantly shown that overconfident investors generally conduct more trades than their less confident counterparts, and those investors who conduct the most trades tend, on average, to receive significantly lower yields than the market.
Overreaction Bias
Investors generally overreact to new information. According to efficient market hypothesis, new information should more or less be reflected instantly in a security’s price. For example, good news should raise a business’ share price accordingly, and that gain in share price should not decline if no new information has been released since. However, reality contradicts this theory. Often, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security’s price. Furthermore, it also appears that this price surge is not a permanent trend. Although the price change is usually sudden and sizable, the surge erodes over time.
Prospect Theory
Traditionally, it is believed that the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. However, research has found that investors don’t actually process information in such a rational way. In 1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses.
Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former, even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains. For example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50. However, despite the fact, most investors view a single gain of $50 more favourably than gaining $100 and then losing $50.
Conclusion
Conventional financial theories do not account for real world situation like emotions and other extraneous factors that influence investors while making investing decisions. However, this is not to say that conventional theory is not valuable, but rather that the addition of behavioural finance can further clarify how the financial markets work.
Works Cited: Phung, A. (2007), retrieved August 30, 2007, from www.investopedia.com, Ritter, J. R. (2003), Behavioral Finance, University of Florida, and Sewell, M. (2007), Behavioural Finance, London: University College London.
Uprety is an analyst at www.merolagani.com
