When news of the COVID-19 pandemic hit, markets plunged in unprecedented ways. These drastic declines played against traditional financial theories such as rational choice theory and efficient market hypothesis, the first of which posits that investors will behave rationally by making decisions that maximize personal utility, or satisfaction, and the second of which states that the price of securities being traded is correct and complete, in that all available information has been factored into the price.
But recent (and past) market peaks and valleys beg the questions – is it realistic to assume investors are 100% rational, and if efficient markets exist, how can there be “bubbles”?
Behavioural finance attempts to shed light on these two key questions, proposing that psychological influences and heuristics, or biases, affect our financial behaviours. These influences and biases can help explain all types of stock market anomalies, such as severe rises or falls in stock price.
Much of behavioural finance involves identifying and categorizing common behavioural patterns that defy the rational choice theory.
Behavioural finance assumes that investors are not perfectly rational and self-controlled but rather persuaded by both external and internal influences. The findings related to behavioural finance studies are applicable well beyond investing and provide insight into almost every financial decision.
Assessing risk and probability: Some insight into human behaviour
Dan Kahnemann and Amos Tversky pioneered a model that reflects human behaviour more accurately than the rational choice theory. Termed “prospect theory,” it describes how choices are made between alternatives where risk is involved, and the probability of different outcomes are unknown.
Prospect theory provides two key insights into human behaviour that are directly related to financial decision making:
- Loss aversion: A person’s negative response to financial loss is greater than positive feelings about financial gains, even when the size of the gain is greater than the size of the loss.
- Assessing probability: We tend to overweight low probability events, especially events that are highly publicized by the media. Conversely, we tend to underweight high probability events that are sufficiently common.
Being mindful of these factors can help us make more objective financial decisions in the face of risk and uncertainty.
How investors can identify and minimize biases
Heuristics, or biases, are an approach to decision making that provide part of the explanation as to why we make decisions that do not provide us with the highest utility, or satisfaction. Heuristics are those mental shortcuts individuals use to conserve mental energy. For example, if it is cloudy when we leave for work in the morning, we may grab an umbrella without giving it much thought.
This thought process is intuitive, experience based, and relatively unconscious. For these reasons, we default to this strategy when under pressure to make a quick choice. While this decision process is mentally efficient, the danger is that without balancing our biases with reflective and analytical consideration, investors are bound to make errors.
In order to minimize the influence of biases, investors need to identify their biases. The following are a sample of common biases that lead investors to make irrational investment decisions:
- Disposition bias: When investors sell their winners and hang onto their losers. This bias generally occurs because people dislike losses more than they like gains. Compounding this bias is the reality that most investors tie investment performance to purchase price, disregarding current conditions and assessing future potential relative to the original purchase price of the security.
- Confirmation bias: The downplaying of information that contradicts a person’s belief while accepting information that confirms initial beliefs. This occurs even if the information is flawed.
- Experiential bias: When investors experience an event, they are more likely to overestimate the probability of that event happening again. This belief is held even when it contradicts the historical norm.
- Familiarity bias: The tendency for investors to invest in what they know, such as domestic companies or locally owned investments. As a result, investors are not adequately diversified.
Do you hold any of the biases above? Have they affected your investments? Identifying your biases might serve as an opportunity to realign your portfolio.
Towards evidence-based financial decisions
The field of behavioural finance is about understanding an investor’s decision in context of multiple factors, including their psychological and cognitive processes. Having a basic understanding of behavioural finance helps the individual investor to self-identify when they are making decisions at the intuitive or subconscious level.
After identifying these biases and influences, we as investors can then inject additional evidence-based analysis into our financial decisions.
Chris Wyman, CPA, CMA, is the Vice President, Learning and Development at Learning Strategies Group, a company that provides tailored training services and learning solutions.