The central issue in behavioral finance is
explaining why market participants make systematic errors contrary to the
assumption of rational
market participants. Such errors affect prices and returns,
creating market inefficiencies. It also investigates how other participants
take advantage (arbitrage) of such market inefficiencies.
Some of the following traits
know as heuristics follow.
Psychology concepts that affect
the way you manage your investments.
In psychology and more
specifically Behavioral Finance, heuristics are simple, efficient rules of
thumb which people often use to form judgments and make decisions. They are
mental shortcuts that usually involve focusing on one aspect of a complex
problem and ignoring others. These rules work well under most circumstances,
but they can lead to systematic deviations from logic, probability or rational
choice theory.
The resulting errors are called
"cognitive
biases" and many different types have been documented. These
have been shown to affect people's choices in situations like valuing a house
or deciding the outcome of a legal case and in making financial decisions.
Heuristics usually govern automatic, intuitive judgments but can also be used
as deliberate mental strategies when working from limited information.
"Investors are 'normal,'
not rational." Behavioral finance reconciles the discrepancy between
rational valuation and irrational market pricing. It's a booming field of
study. Top behavioral finance gurus include Yale's Robert Shiller and GMO's
James Montier.
There are several common
behavioral biases that drive investor decisions.
Availability Bias is
the ease with which a particular idea can be brought to mind. When people
estimate how likely or how frequent an event is on the basis of its
availability, they are using the availability heuristic. When an infrequent
event can be brought easily and vividly to mind, this heuristic overestimates
its likelihood. For example, people overestimate their likelihood of dying in a
dramatic event such as a tornado or terrorism. Dramatic, violent deaths are
usually more highly publicised and therefore have a higher availability. On the
other hand, common but mundane events are hard to bring to mind, so their
likelihoods tend to be underestimated. These include deaths from suicides,
strokes, and diabetes. This heuristic is one of the reasons why people are more
easily swayed by a single, vivid story than by a large body of statistical
evidence. It may also play a role in the appeal of lotteries: to someone buying
a ticket, the well-publicised, jubilant winners are more available than the
millions of people who have won nothing.
When people judge whether more
English words begin with T or
with K, the availability
heuristic gives a quick way to answer the question. Words that begin with T come more readily to mind and so
subjects give a correct answer without counting out large numbers of words.
However, this heuristic can also produce errors. When people are asked whether
there are more English words with K in
the first position or with K in
the third position, they use the same process. It is easy to think of words
that begin with K, such
as kangaroo, kitchen, or kept. It is harder to think of words with K as the third letter, such
as lake, or acknowledge, although objectively
these are three times more common. This leads people to the incorrect
conclusion that K is
more common at the start of words.
Investors believe they are
awesome at investing
Overconfidence may
be the most obvious behavioral finance concept. This is when you place too much
confidence in your ability to predict the outcomes of your investment
decisions. Overconfident investors are often under diversified and thus more
susceptible volatility.
Investors are bad at processing
new information.
Being
poor and processing new information is known as Anchoring and
is related to overconfidence. For example, you make your initial investment
decision based on the information available to you at the time. Later, you get
news that materially affects any forecasts you initially made. But rather than
conduct new analysis, you just revise your old analysis. Because you are
anchored, your revised analysis won't fully reflect the new information.
Investors connect the wrong
things to each other.
Representativeness - A
company might announce a string of great quarterly earnings. As a result, you
assume the next earnings announcement will probably be great too. This error
falls under a broad behavioral finance concept called “heard investing.” A lot
of investors incorrectly think one thing means something else. Another example
of representativeness is assuming a good company is a good stock.
Investors absolutely hate
losing money.
Loss aversion, or
the reluctance to accept a loss, can be deadly. For example, one of your
investments may be down 20% for good reason. The best decision may be to just
book the loss and move on. However, you can't help but think that the stock
might comeback.
This latter thinking is
dangerous because it often results in you increasing your position in the money
losing investment. This behavior is similar to the gambler who makes a series
of larger bets in hopes of breaking even. This Heuristic leads largely into another
heuristic known as gamblers Fallacy, which can be best described as flipping a
coin 100 times and the first 99 flips have all been tales. Gamblers fallacy
indicates that most of us would bet on the fact the next flip has to be heads.
Even though the odds have not changed and as a standalone flip of a coin, the
odds are still 50/50.
Investors have trouble
forgetting bad memories.
How you invest your money in
the future is often affected by the outcomes of your previous experience. For
example, you may have sold a stock at a 20% gain, only to watch the stock
continue to rise after your sale. And you think to yourself, "If only I
had waited." Or perhaps one of your investments fall in value, and you
dwell on the time when you could've sold it while in the money. These all lead
to unpleasant feelings of regret.
Regret minimization (Fear of
regret) occurs when you avoid investing altogether or invests
conservatively because you don't want to feel that regret. This is the human
psyches was of protecting ourselves from unwanted emotions.
Investors are great at coming
up with excuses.
Sometimes your investments lose
money. Of course, it's not your fault, right? Defense mechanisms in
the form of excuses are related to overconfidence. Here are some common excuses:
·
'if-only': If only that one thing
hadn't happened, then I would've been right. Unfortunately, you can't prove the
counter-factual.
·
'almost right': But
sometimes, being close isn't good enough.
·
'it hasn't happened yet':
Unfortunately, "markets can remain irrational longer than you and I can
remain solvent."
·
'single predictor': Just
because you were wrong about one thing doesn't mean you're going to be wrong
about everything else.
