Behavioural finance: making more rational investment decisions

If someone has two shares, one of which experienced a loss of 15% and the other a profit of 15%, that person is likelier to sell the second share if they need capital. From a rational perspective, it is important to sell those shares that have poor prospects. Yet our subconscious tells us to try and aim for success by selling the winning share, rather than sell the losing share and admit we’ve suffered a loss. The share could well increase in value, after all. 

This is exactly the sort of behaviour that behavioural financial market theory studies. It shows investors what prompts investment decisions, and how irrationally these decisions are made despite their very best efforts to try and think rationally. People investing actively in particular run the risk of behaving more irrationally than they would like (or rather than they think they are). 

People and markets do not follow set models and theories.

Behavioural financial market theory is an area that was shaped by psychologists Daniel Kahneman and Amos Tversky, as well as by economist Richard Thaler, who together came up with numerous theories and models to do with behavioural finance. One thing they showed was that different models of theoretical and behavioural economics do not actually exist in real life:  

• the fictitious model “Homo oeconomicus” assumes that players in the financial world are completely rational in their actions and are solely motivated by their own interests. The fact is, however, that the decisions people make are not just influenced by rational factors, they are also heavily influenced by irrational behaviour and subconscious actions and patterns.
• In financial theory, reference is often made to the “efficient markets” model (also known as the Efficient Market Hypothesis). According to this theory, financial markets are efficient in the way they work. This means that the prices achieved reflect all the information that is available on these markets. In other words, the hypothesis states it is impossible to make immense profits as a result of a purported information advantage. The trouble is, though, that this only works if investors only ever behave in a rational way. Herd behaviour and panic selling, according to behavioural finance, go to show that people act irrationally on the stock markets. What this means is prices do not always follow an efficient pricing pattern. 

In an ideal world where “Homo oeconomicus” and “efficient markets” are the norm,  the (completely rational) investors would have all the information available on the market at their disposal, they would be able to classify it flawlessly and use it to draw purely logical conclusions. The fact is, though, that investors behave irrationally, they view certain information as more or less important than it really is, and this leads them to make  poor investment decisions.  Behavioural financial market theory explains why this is the case – and why it is that these decisions being made over and over again results in supposedly illogical developments on the markets. Investors who recognize these influencing factors and are able to classify them will be able to adjust their strategies accordingly.

Overconfidence

We tend to try and look for what appear to be patterns and justify our reasoning afterwards. For example: if a fund regularly increases significantly in value at the end of the year, we would expect the same to happen over the coming years, without carefully considering whether the years and developments we have witnessed so far are truly representative. Essentially, we overestimate our ability to spot rational patterns. Investment decisions can also be influenced by several other “reasoning errors” and “pitfalls” that investors keep falling into. For instance: 

Cognitive dissonance

In our lives, we are prone to making the odd wrong decision, and admitting this is often very hard to do. This is why we prefer to try and look for reasons and excuses to justify what we think is the right decision, rather than admit we got it wrong so we can learn from it. An investor may, for instance, buy a share they are confident about, but which goes on to do much worse than they had anticipated. Rather than sell on the share and accept a loss, they just carry on buying these shares to keep the average purchase price as low as possible. 

Distorted risk perception

We generally struggle to assess risks properly. Investors often deem unpopular shares to be too risky, so they steer clear. Instead they prefer to invest in so-called “hot shares” that have a strong track record because they feel more confident about them. This means that popular shares are often overrated, whilst unpopular ones are frequently underrated. 

Selective perception

“News bubble” is a term that has been on everyone’s lip in recent years. In order to sort out all the information we are bombarded with on a daily basis, we need to select (i.e. classify) what information is important or accurate, and what information is unimportant or inaccurate. This leads to us filtering information where we give preference to any information that backs up our own preconceived notions or decisions we have already made. If we purchase a share and go on to read that it will perform fantastically, we will give this information more weight than other articles that suggest it might do badly. 

Mental accounting

We keep a mental account of everything we do in our lives. This means we treat different events in different ways. Investors who invest in different asset categories do not think about the return on their investment or the potential risks as a whole. Instead, they continue investing in each individual asset category, for instance shares or bonds. They also approach individual “accounts” differently. Mental accounting is even easier to grasp when we look at actual accounts: if, before your next payday, you have the choice of overdrawing your private account by CHF 100 or making a transfer from your savings account, you are likelier to go with the overdraft. After all, a savings account has a completely different status to a private account in a person’s mind. 

Gambler’s Fallacy

The Gambler’s Fallacy is something we keep unwittingly falling for. We operate on the false premise that the longer we go without seeing a random event, the likelier it is to happen (and vice versa). If a stock market correction or even a crash has not occurred for a very long time, we may assume a crash is imminent. Or take the very simple example of tossing a coin: you always have a 50% chance of getting heads or tails. Even if you spin tails three times in a row, the probability of getting another one is still 50/50.

What would you do?

You can see what you would do yourself based on the following examples: 

The rational, calculated response to the first question would have to be A seeing as you are certain to win more money.

A risk-neutral investor might choose both options in response to questions 2 and 3. Individuals with a particularly large risk appetite would answer A to both questions. In response to the second and third questions, studies have shown that the majority of people would answer B (Q2) and A (Q3). This shows us that people prefer a guaranteed win to a potentially higher win. In situations where you are in a position to restrict your losses, you will do just that. People give more weight to losses than to wins worth exactly the same. 

Objective facts help us keep our emotions in check

What does this mean for investors? You should try and be as objective as possible, base your actions on facts and calculate how much you would get in terms of assets for an investment. This requires consistency and discipline, especially if this objective decision-making goes against your usual behaviour or your intuition. Basing your investments on behavioural financial market theory is different to basing them on conventional investment strategies. Behavioural finance does not offer any strategies, it simply helps investors assess how much of an impact emotions and feelings can have on market prices.