Behavioural finance – the study of markets’ unknown sentiments. Amid a geopolitical climate in which financial markets find themselves in a situation with abundant “known unknowns” – from the Russian invasion of Ukraine to the looming recession – taking a close look at the psychology underlying investors’ decisions has gained great salience.
In this week’s special edition of TiL Rundown, Bocconi University’s new student association “Behavioral Finance and Development Economics” introduces you to Behavioural Finance Theories that shed light on a modern way of thinking investment.
Behavioural finance – the study of markets’ sentiments. In a geopolitical era in which markets are vastly influenced by governments’ announcements, whether they are of political, economic, or social nature, investigating the relationship between current news and market developments has gained great salience.
The known unknowns
As the war continues to unfold in Europe, with Russian President Vladimir Putin threatening his enemies with nuclear escalation, the conflict in Ukraine is revealing itself to be one of the most prominent “known unknowns”.
Along with sharp interest hikes conducted by the Fed and a looming recession, coupled with high government deficits, investors are haunted by a growing number of uncertainties.
But don’t worry – behavioural finance can help.
In essence, behavioural finance is an amalgamation of finance as well as behavioural psychology. It is the study of the effects of psychology on investors and financial markets. The problem with Traditional Finance is that it depicts an idealistic world. However, stark contrasts exist between the two.
Traditional versus Behavioural Finance Theories
The Traditional Financial Theory assumes perfect rationality of market agents and investors, following the principle of maximising utility. According to this theory, investors have perfect self-control; cognitive errors therefore cannot occur.
The Behavioural Finance Theory tells us another story, and perhaps a more adequate one: investors are perceived to be “normal” – human – not purely “rational”: they are influenced by their own biases, have limited self-control, and make cognitive errors that lead them to poor decisions.
The general goal of Behavioural Finance is therefore to consider investors’ irrationality in the analysis of market price fluctuations prices for future projections. To be successful at investing, investors not only need to show mastery over numbers but also great command over our thinking and emotions.
Cognitive biases are assumed to be at the heart of erroneous investing. Identifying them before we succumb to them can immensely improve our decision-making.
Today, BFDE is cautioning the reader of this article against eleven biases – false friends – that may impact their cognitive reasoning.
Anchoring Bias
We tend to rely too heavily on the first pieces of information we are presented on a topic. This first information leads us to interpret newer information with a reference point, which leads us to draw false conclusions.
Confirmation Bias
We naturally listen to people who agree with us. While it feels good to hear our own opinions validated, we would be seeking out agreeable information that can lead to unfair judgment.
Framing Bias
We typically judge information by how it was presented rather than at face value. Changes in phrasing, or how the problem was “framed” influence how we perceive the facts and lead to people drawing different conclusions.
Hindsight Bias
We often happen to be convinced by the power of retrospect that after something happened, we knew about it all along. This leads us to falsely assume that we are apt to accurately predict other events.
Loss Aversion
Manifestly, we are more psychologically hurt when we experience a real or potential loss rather than an equivalent gain. For instance, we would rather not lose $10 than gain $10.
This perception of loss and gain alludes to the Prospect Theory famously developed by Daniel Kahneman and Amos Tversky in 1979.
Illusion of Control
We tend to overestimate how much control we have over the outcome of uncontrollable events. This behaviour is common in superstition, gambling, and paranormal beliefs.
While predictions of the market affect the future of the market, the following series of events triggered are not guaranteed to happen predictably. The financial market system is made up of people such that the latter can act in an irrational way, making the entire system unpredictable.
Illusion of Knowledge
We like to think that the accuracy of our forecasts increases with more information.
Narrative Fallacy
Stories govern the way we think and decide. We will often abandon evidence in favour of a good story. Typically, admired stocks come with great stories and high prices.
Herd Mentality
We are hard-wired to herd. In general, going against the crowd or non-conformity triggers fear in people. Led by emotion and instinct, we tend to follow and copy what other investors are doing.
Crowd psychology is crucial to behavioural finance. The underlying assumption is that individuals behave differently as an individual as compared to when they are in a group. Since markets are formed of groups of people, the group has a major influence on the behaviour of individuals.
Endowment Effect
We tend to place a higher value on what we already own. When a person owns stock or an investment, they often become emotionally engaged with the object and value it. This implies that the seller of an object typically values it higher than the buyer.
For instance, the valuation of the company can depend upon whether the evaluator owns a stake in it. This is a common reason for overvaluation of the portfolio, holding on to a mediocre stock and developing the “hold” recommendation.
Recency Bias
We have a tendency to want quick results and do not sufficiently value track records. Recency bias causes investors to place less importance on fundamental value and put undue emphasis on recent performance.
People with short-term goals often fail to perform well in the stock market. The common saying “In the short run, the markets are a voting machine whereas, in the long run, they are a weighing machine” emphasises the role of long-term investment.
Finding the intrinsically human part of investing
Ultimately, investing remains a probabilistic activity. Behavioural studies, however, help us take into consideration an abundance of factors that direct us towards fallacious reasonings – for the simple motive that we are tied to behavioural patterns that first need to be detected to then be acted upon, that require critical thinking as a necessary condition. It is precisely in this vein that Behavioural Finance and Development Economics sheds light on the components and variables of probabilistic models that are otherwise neglected. That is, to discern the intrinsically human part of investing. For those Bocconianis who are interested: BFDE might be of help.
BFDE is a student association at Bocconi University. Founded in 2022, it aims to promote student research and understanding of the intersection between investor psychology and the economic progress of developing countries.
References
Behavioral finance glossary. Corporate Finance Institute. (2020, March 29). Retrieved October 4, 2022, from https://corporatefinanceinstitute.com/resources/knowledge/finance/behavioral-finance-glossary/
Behavioral science, applied. The Decision Lab. (n.d.). Retrieved October 4, 2022, from https://thedecisionlab.com/
MSG Management Study Guide. Behavioral Finance – An Introduction. (n.d.). Retrieved October 4, 2022, from https://www.managementstudyguide.com/behavioral-finance.htm
BFDE is a student association at Bocconi University. Founded in 2022, it aims to promote student research and understanding of the intersection between investor psychology and the economic progress of developing countries.