Behavioural Finance

What is Behavioural finance?

Behavioural finance is one of the sectors of the new “behavioural economics” which consists in applying psychology to finance. Born some thirty years ago, this theory was officially recognized in 2002 with the award of the Nobel Prize in Economics to its two fathers, Daniel Kahneman and Vernon Smith. His study focuses on the behaviour of investors in their decision making.

As opposed to the basic hypothesis of efficient markets, this theory will seek to highlight situations in which markets are not rational and will try to explain the causes by the psychology of investors. In other words, it will identify the shortcomings of human behaviour as well as their effects on the markets in order to use them in investment strategies.

According to standard financial theory, financial markets achieve the most economically efficient equilibria as if they obeyed purely rational rules. The postulate of behavioural finance is totally different.

Indeed, it considers that the investor is not always rational and that his feelings are subject to systematic errors of judgement (called “cognitive bias”) or to emotional factors such as fear or overconfidence, which interfere with his decision-making.

 

What are the most common cognitive biases in behavioural finance?

1. Overconfidence

Overconfidence refers to our tendency to overestimate our abilities (intellectual or otherwise) more than they actually are. For example, 82% of people say they are among the 30% most cautious people at the wheel. Moreover, when people claim to be 90% sure of something, studies show that they are right only 70% of the time.

Such optimism is not necessarily a bad thing. Nevertheless, overconfidence can be a source of disappointment, especially when you think you’ve discovered a new nugget on the stock market. The reality is that this is rarely the case. Studies show that overconfidence leads investors to buy/sell faster because they are convinced they know more than their counterpart.

However, it should be remembered that transaction costs (commissions, taxes, losses linked to the bid-ask spread) have an unfortunate tendency to penalise returns. These friction costs will always weigh on the final return of an investment.

One of the factors that lead many traders, in addition to overconfidence, is the illusion of being in control. Being more present in the monitoring of our investments can give us this illusion of having more control over our finances, but there is a certain point where too much control can be harmful, as some studies have shown.

 

2. Selective memory

The other danger of overconfidence is selective memory. Our memory tends to isolate painful or distressing events, especially those that are the consequence of our own actions. When it comes to investing, we tend to forget good ideas that we did not buy or those that led to substantial losses.

The more confident we are, the more these negative experiences affect our self-esteem. How can one be a good investor if one is capable of such mistakes? Rather than remembering the past accurately, in fact, we selectively recall the past according to our needs or how it preserves our image.

Integrating information in this way is called “cognitive dissonance”, a well-known case in psychology. This notion means that we are uncomfortable with disparate ideas, opinions, beliefs, attitudes or behaviours and our psyche will need to balance them out.

Correcting a choice from the past, especially if we think we are a wise investor, deserves to adjust our memory to this unfortunate choice. “Maybe it wasn’t such a bad decision to sell this stock? “Or, “Maybe I didn’t lose as much money as I thought I would.” Over time, our memory of events will become less accurate to adjust to what we want to remember.

Another type of selective memory is representational bias, which causes us to give more weight to recent evidence – short-term performance figures – and less weight to a more distant past. This leads us to give little weight to events that have a real probability of occurring.

 

3. Self-denigration

Researchers have identified another bias that is the opposite of overconfidence. Self-deprecation occurs when one tries to explain any future disappointing performance with a reason that may or may not be true. A classic example is saying that you don’t feel good before a presentation, so that if something goes wrong, the explanation will be found.

As an investor, this bias exists, for example, when one admits that one did not spend enough time studying a stock as one would have done in the past, in case the investment did not produce the expected results. Overconfidence and self-disparagement are common among investors, but they are not the only things that can affect the performance of our decisions.

 

4. Risk aversion

It’s no surprise, but even if most lines in a portfolio are in the green, investors will tend to be obsessed with stocks that are losing money. This behaviour is called risk aversion. This makes them more inclined to sell stocks that are making money rather than cutting positions in the red.

Regret can also play a role in risk aversion. It can lead us to distinguish between a bad decision and a bad outcome. We regret bad results, for example when a stock aligns down phases when we had chosen it for all the right reasons. In this case, regret can lead us to make the wrong decision to sell, such as selling a stock at its lowest historical levels instead of buying more.

In addition, the pain of losing money is felt more strongly than the pleasure of making money. Moreover, it is the refusal to accept the hardship of a loss that can lead us to maintain a position on a stock in the vain hope that it will eventually make us earn money.

 

5. The unrecoverable cost

Another factor that can affect risk aversion is the unrecoverable cost. We cannot ignore the irrecoverable cost of a decision. For example, if we buy tickets to a particularly expensive concert only to learn beforehand that it will be a disappointment. Because the tickets have been paid for, we will tend to attend the show anyway, something we probably would not have done if the tickets had been given to us by a friend.

Rational behaviour should lead us to choose whether or not to go to the concert based solely on our interest, not on whether or not we bought the tickets. Our inability to ignore the unrecoverable cost of a disappointing investment can lead us to misjudge certain situations on their own merits alone.

Irrecoverable costs may lead us to hold a security in the portfolio even if the underlying business deteriorates, rather than cutting our position. If the losing stock had been given to us, perhaps we would have decided to sell it long ago.

 

6. Anchoring

Demandez aux habitants de Toulouse d’estimer la population de la ville de Strasbourg. Ils se baseront systématiquement sur le chiffre qu’ils connaissent et l’ajusteront à la baisse, tout en restant au final loin du compte. Lorsque nous tentons d’estimer l’inconnu, nous nous basons sur ce qui nous est familier.

Les investisseurs font de même. Ils prennent référence dans leur estimation des résultats d’une entreprise ou dans les résultats de l’année passée. L’ancrage conduit donc un investisseur à accorder plus d’importance aux informations connues ou immédiatement observables (les performances récentes), lesquelles influenceront leur décision d’investir.

Lorsqu’un investissement ne produit pas les résultats escomptés, nous prêtons plus d’attention à sa performance avant un déclin plutôt qu’au prix effectivement payé. Nous pouvons ainsi rester « attachés » à des sociétés de qualité moindre, plutôt que de s’en débarrasser. Cet attachement à de tels titres peut faire perdre de l’argent et nous faire manquer d’autres opportunités d’investissement bien plus intéressantes.

 

7. Confirmation bias

Another risk that comes from overconfidence or anchoring affects the way we look at information. Too often we tend to extrapolate our own beliefs without realizing that we are engaging in confirmation bias, or we process information that is consistent with what we believe, or would like to believe.

For example, if we buy a fund that specializes in the health sector, we tend to put more emphasis on the good news about it rather than incorporating potential bad news. Stepping back from a past event is one way to combat this type of bias. It is a matter of re-evaluating past behaviour in relation to an event or decision in the light of the actual outcome observed.

For example, knowing the performance obtained from holding a security could have led us to reconsider the interest in buying it. This type of behaviour makes it possible to take a more objective look at the way certain investment decisions are made.

 

8. Mental segmentation

If a friend tells you that he cannot spend a certain amount of money because it is earmarked to finance his vacation, you are dealing with a case of mental segmentation. Our mind leads us to allocate money by themes or categories – funding children’s education, money for retirement, money for the house or car.

Investors can take advantage of such cognitive bias. “Marking” money for retirement funding will prevent you from spending it frivolously. Mental segmentation becomes a problem, however, when you categorize funds without keeping an overview.

An example of this is a tax refund – money that is sometimes seen as money that can be spent without thinking too much about it. Since it is in fact income, it should not be considered that way. When it comes to investment, just remember that money is money, whether it comes from a securities account, from the fruits of your savings, from an inheritance or from a capital gain on the disposal of an asset.

 

9. The formulation effect

The formulation effect refers to another bias that can affect your decision-making ability. Suppose, for example, you decide to buy a television. But just before you pay $500 for this purchase, you realize that the same model is $100  cheaper in a shop a little further away. In this case, you are likely to go to that store to buy a cheaper TV.

If, however, you are considering buying a set of sofas and armchairs worth a total of $5,000 , and you know that a shop offers you the same set for $4,900 , you are unlikely to make the trip. Why is that? Don’t you want to save $100? Unfortunately, we tend to think in relative terms (the weight of the $100 in the total amount of the purchase) rather than in absolute terms ($100).

In the case of the television set, the saving is 20%, in the next case, 2%… To avoid the negative effects of such a cognitive bias, the best mental disposition is to focus on the total return on our investments, and not to reason too much in terms of an overly segmented approach, to the point where we lose sight of the fact that seemingly small decisions can have a consequent impact in the end.

 

10. Sheep behaviour

There are hundreds of stocks available on the markets. Investors can’t know them all. In fact, it is difficult to know even a few stock well. But investors are bombarded with investment ideas from the media, brokers, magazines, websites.

In the end, it often happens that a decision is made to invest in a new stock that is presented as a much better idea than what is already in the portfolio. Unfortunately, in many cases, stocks that capture so much attention do so because they have already had a very good run in the stock market, not because their fundamentals were improving.

Deciding to buy a stock under such circumstances is sheepish behaviour. This is not to say that investors should not listen to their environment. But their portfolio management should respond to factual, fundamental data, rather than to the movements of the stock market and other investors.

We can all become better investors if we learn to select stocks carefully and for the right reasons, and to avoid listening to market noise when we do so. Any sense of security that comes from investing in the same direction as the rest of the market or on the advice of investment “gurus” can only lead to disappointing results.

 

How do emotions affect our financial decision?

OTHER BIASES, FINANCIAL OR OTHERWISE…

 

Confirmation bias: is the very common tendency to seek and consider only information that confirms beliefs and to ignore or discredit information that contradicts them.

 

Belief bias: occurs when judgment about the logic of an argument is biased by belief in the truth or falsity of the conclusion. Thus, errors in logic will be ignored if the conclusion is consistent with beliefs. Maintaining certain beliefs can be a very strong motivation: when beliefs are threatened, the use of unverifiable arguments increases; misinformation, for example, relies on the power of beliefs: why does misinformation work?

 

Self-indulgence bias: is the tendency to take credit for one’s successes and attribute one’s failures to unfavourable external factors.

 

Fundamental attribution error: is the tendency to overestimate personal factors (such as personality) to explain other people’s behaviour and underestimate situational factors.

 

The halo effect: occurs when the perception of an individual or group is influenced by one’s previously held opinion of one of their characteristics. For example, a person with good physical appearance will be perceived as intelligent and trustworthy. The notoriety effect is also a halo effect.

 

Retrospective bias: is the tendency to overestimate, once an event has occurred, how predictable or probable it was.

 

Overconfidence: is the tendency to overestimate one’s abilities.

 

Negativity bias: is the tendency to give more weight to negative experiences than positive ones and to remember them better.

 

The Barnum Effect: consists of accepting a vague description of personality as applying specifically to oneself. Horoscopes play on this phenomenon.

 

Dispossession aversion (or endowment): refers to a tendency to assign a higher value to an object that one possesses than to the same object that one does not possess. For example, a homeowner might estimate the value of his or her home to be higher than what he or she would be willing to pay for an equivalent home.

 

The illusion of correlation: consists of perceiving a relationship between two unrelated events or exaggerating a relationship that is weak in reality. For example, the association of a particular characteristic in a person with the fact that he or she belongs to a particular group when the characteristic has nothing to do with the fact that he or she belongs to that group.

 

Framing bias: is the tendency to be influenced by the way a problem is presented.

 

Anchoring bias: is the tendency to unduly use information as a reference. It is usually the first piece of information acquired on the subject. This bias can occur, for example, in negotiations, shop sales or restaurant menus. In negotiations, making the first offer is advantageous.

 

Representativeness bias: is a mental shortcut that consists in making a judgment based on a few elements that are not necessarily representative. It is an extrapolation bias.

 

Memory availability bias: consists in making a judgment on a probability according to the ease with which examples come to mind. This bias can, for example, lead to taking a recent event as frequent.

 

Status quo bias: is the tendency to prefer to leave things as they are, with change appearing to bring more risks and disadvantages than possible benefits. In various areas, this bias explains choices that are not the most rational.

 

Omission bias: is the view that potentially causing harm through action is worse than causing harm through inaction.

 

False consensus bias: is the tendency to believe that others agree with us more than they actually do. This bias can be particularly present in closed groups where members rarely meet people who disagree and have different preferences and values.

 

Belief in a just world: is the tendency to believe that the world is just and that people deserve what happens to them. Studies have shown that this belief often meets an important need for security. Different cognitive processes operate to preserve the belief that society is just and fair despite evidence to the contrary.

 

The illusion of knowledge: consists of relying on erroneous beliefs to apprehend a reality and not seeking to gather further information. The situation is wrongly judged to be similar to other known situations and the person reacts in the usual way.

 

The Dunning-Kruger effect: is the result of cognitive biases that cause the least competent people to overestimate their skills and the most competent to underestimate them.

 

Conformism bias: the tendency to think and act as others do. This is sheep-like behaviour.
The boomerang effect: is the phenomenon whereby attempts at persuasion have the opposite effect to that expected. Initial beliefs are reinforced in the face of conflicting evidence.

 

The illusion of control: is the tendency to believe that we have more control over a situation than we actually do. An extreme example is the use of lucky objects.

 

The effect of simple exposure: is an increase in the likelihood of a positive feeling towards someone or something by the simple repeated exposure to that person or object. This cognitive bias may be present in the response to advertising, for example.

 

How Behavioral Finance Can Help You Invest Wisely?

 

There are two solutions to avoid the pitfalls of behavioural finance:

1. Taking a step back and relying on evidence to invest (Keep a cool head and, knowing the biases that await you, analyze your investment decisions with great lucidity.)
2. Using an investment professional and a robot-advisor (Rely on the experience and expertise of a professional investor, or even a robot-advisor, who will make decisions based on factual data, in a very rational manner.)

 

1. Taking a step back and relying on evidence to invest

By having a good knowledge of these very human biases, you will be able to identify them when they arise in your investment decisions. You will therefore be able to control them as well as possible.

Be inspired by Warren Buffett’s method, whose super performances are based on a very high level of discipline, including buying at a predetermined price and selling at an equally predetermined price, regardless of the influences of the moment. Why not provide for a systematic sale when the price has fallen by a certain percentage or, conversely, has achieved a certain performance?

Learn from your mistakes too! Take account of the biases you may have had in the past and how they have affected your investment decisions, with what results. For example, ask yourself: “Do I always think I’m right”; “Do I take undue risks with certain investments and then blame external factors for my losses? “Have I ever bought a security just because I had a good feeling, apart from all other considerations? ».

Finally, and perhaps most importantly, ask yourself in the future whether you have all the information you need to make the right investment choices. Although it is impossible to know everything about a security before you buy or sell it, thorough research will help you invest based on logic and objective knowledge rather than your own prejudices or emotions.

 

2. Using an investment professional and a robot-advisor

To avoid the bias trap, you can also decide to rely on the experience and expertise of a professional by investing in a UCITS, for example.

For example, investor aversion to losses and the disposition effect is much less present among professional investors. For example, Mickaël Mangot, author of the book “Investor psychology” explains in Morningstar’s columns: “We can see that around 35% of financial professionals have this bias, compared with a proportion of around 70% among individual investors”.

A 2001 study by Shapira and Venezia also showed, by comparing two samples, one professional investor and the other individual investor, that the latter suffered much less from the disposition effect. A professional manager, even without a quantitative approach, will put more emotional distance between the managed portfolio and performance, probably allowing for better decision-making.

 

How can learning behavioural finance help us and our customers?

Behavioural finance can be useful for a financial planner, in particular by enabling him or her to better communicate with clients, better understand their cognitive biases and help them become more engaged in their financial planning.

You have to understand yourself, understand your own biases such as impatience or procrastination. Put yourself in the clients’ shoes and realize that they are not trained the same way as you are and that they can make mistakes.