Understanding and Overcoming Investor Irrationality - IFSA Network (2024)

What is Behavioural Finance?

Picture this: you’re at the theatre to see the latest movie- it’s a hit and they’re just about to reveal the masked hero’s identity- and that’s when the lights come on- it’s time for intermission. For most of us, this means that a familiar choice awaits: a small co*ke or a large co*ke. It seems like a straightforward decision, one based on your immediate thirst. However, bring in a medium sized co*ke, priced just a bit higher than the small but slightly lower than the large size, and you find yourself drawn to the large size, even if it may not actually be the better deal or even a practical choice at that.

This is just one example of how human perception and emotion can influence financial decisions- be it something as trivial as the co*ke dilemma or high stakes decisions like those being made right this very second on wall street. And this is precisely what behavioural finance seeks to explain: the intersection of psychology and finance. Behavioural finance is the study of how cognitive biases and psychological factors affect financial decision making and often lead to choices that may be irrational/suboptimal when viewed from a purely logical perspective.

Traditional Finance Theory vs Behavioral Finance Theory?

In the world of finance, there are two competing theories: Traditional Finance and Behavioral Finance. Traditional finance assumes people always make rational decisions and markets are perfectly efficient. It includes the following provisions:

• Both the market and investors and perfectly rational.
• Investors possess perfect self-control with respect to financial decisions.
• They remain unaffected by cognitive mistakes or errors in processing information.

On the other hand, Behavioural finance theory lists down the traits of investors as follows:

• Investors are ‘normal’ and not ‘rational’
• They are disproportionately influenced by bias
• They often make cognitive errors that lead to incorrect decisions

Behavioral Finance, however, acknowledges that humans are not always rational and that emotions influence decisions. In this article, we’ll explore the clash between these theories, how they impact real-world finance, and why understanding both is crucial in today’s financial landscape.

Bias Revealed by Behavioral Finance

One of the key concepts of behavioural finance is occurrence of bias. Behavioural finance provides an explanation to the following types of bias that influence the financial decisions made by an individual or an organization:

1. Anchoring Bias

Anchoring bias happens when individuals place excessive reliance on an existing piece of information or the initial information they encounter when making decisions. It has its ground on the understanding that a benchmark price influences an individual’s decision making disproportionally. One simple example of an anchoring bias would be predicting the future price of a stock solely based on its current price. In this case, the current price is the anchor and other factors do not influence the prediction made. To shield oneself against this, the decision maker must critically analyse all possible factors that are likely to influence the final decision.

2. Loss Aversion

Based on “a bird in hand is worth two in the bush”, loss aversion refers to the tendency of an investor to prioritize avoiding losses over pursuing gains due to a strong fear of losing. The more a person encounters losses, the greater is their susceptibility to experiencing loss aversion. Research on loss aversion indicates that the investor feels the emotional impact of a loss more than twice as intensely as the satisfaction derived from making a profit. An instance of loss aversion is investing in low return but guaranteed stocks instead of high return risky ones.

3. Herd Mentality

As the name explains, herd mentality implies the practice of blindly following others’ financial decisions with less or no independent research and analysis. Such people are highly influenced by comparison and replicate others. To exemplify, if a person A sees that most people are investing in Apple’s stocks at a given point of time, he/she would do the same without analysing the reasons behind it. Going against the masses misleads people to thinking that they might be doing something “wrong” which might not always be true. One of the reasons which led to the Global Financial Crisis in 2008 is herd mentality. History has it that individual investors and financial institutions overly engaged themselves in risk-taking and housing market speculation, without any research. Subsequently, this led to a collapse of the market.

4. Heuristic Simplification

It implies ‘oversimplification’ of the decision making process by individuals. It is an example of a cognitive bias that leads to an individual considering only some part of the information. Another reason could be overconfidence in their own knowledge and ignoring the expertise of other professionals. It can be indirectly called an egoistic belief of believing to be better than what you actually are. James Montier, an expert in the field of behavioural finance, conducted a survey of over 300 professional fund managers. They were asked if they were confident in their ability to invest. Some 74% of the respondents rated themselves ‘above average’ while the rest 26% thought they were ‘average.’ Nobody believed themselves to be ‘below average’ highlighting the overconfidence that most of them had in themselves. Learn more about his study here.

Types of Overconfidence in Financial Markets

• Illusion of Control It occurs when people believe they have complete or partial control over a situation when, in reality, they do not. This can be dangerous in business or investing, as this leads to thinking that the situation is less risky than it actually is.
• Timing Optimisation This is another side of overconfidence which highlights how people tend to overestimate how fast they can work and underestimate how long it takes to do something. In financial terms, investors often underestimate how long it might take for an investment to pay off.
• Over Ranking Overestimation occurs when an individual assesses their own performance as superior to its actual level. As stated earlier, most people tend to view themselves as above-average. In the realms of business and investing, this tendency can pose significant challenges, often resulting in the acceptance of excessive risk.

5. Confirmation Bias

Let us say that you want to buy the shirt that has been trending lately and look on the internet to check its reviews. The search results reveal that its fabric is itchy. People with a confirmation bias will simply reject this contrary information. It is the ability of people to focus only on details that confirm their belief and overlook the information that contradicts it. It limits rational financial decisions even though the person performs the necessary research. Individuals tend to search for evidence and information that affirms their views and opinions. It prevents people from trusting information that opposes their views, resulting in irrational decisions, irrespective of the fact that it might be true.

6. Hindsight Bias

This aspect of behavioural finance encourages individuals to overvalue their guesses, when in reality, they were a mere coincidence. For instance, if an investor sells a stock just before the price drops, he might believe that he knew it would decline, instead of focusing on the actual reason behind selling. He/she might come to believe that they possess a special talent or insight with regards to predicting an outcome. To avoid the hindsight bias, one must map all possible outcomes of a financial decision fairly and learn from wins and losses. The hindsight bias prevents one from realising their mistake and limits the learning.

7. Experiential Bias

Also known as the availability or recency bias, it occurs when individuals allow recent events or experiences to influence the decisions they make, even if it is irrational. It causes the investor to believe that something is more likely to occur than it actually is. This occurs because their recent experiences mislead them into framing a strong opinion about a particular topic. Example, if an investor goes out of the way and takes a risk by investing in an online marketplace startup and faces losses, he or she is more likely to never invest there again. This judgement is inaccurate because that particular startup might not have worked for a variety of reasons, but it is irrational to think that this will happen with all startups.

Market Anomalies Attributed to Behavioral Finance

Market anomalies refer to patterns or events in the financial markets that diverge from the forecasts made by conventional finance models, frequently attributed to the impact of behavioural biases. Below, we talk about some market abnormalities that are defined and described by the concepts of behavioural finance :

1. Momentum Effect

The momentum effect is when assets that have recently performed well tend to keep doing better, while assets with poor recent performance continue to lag behind. This phenomenon can be attributed to investors’ tendencies to overreact, underreact to new information, and follow the crowd due to herd mentality.

2. Size Effect

It is the tendency of smaller companies to generate higher risk-adjusted returns as compared to larger companies. This anomaly can be attributed to behavioural biases such as investors’ neglect of small-cap stocks and the overestimation of large-cap stocks’ growth potential.

3. Value and Growth Stocks

Value stocks are those that have been undervalued for long based on their financial fundamentals, while growth stocks are those anticipated to have above-average growth potential. According to behavioural finance theories, value stocks often outperform growth stocks because of investors’ tendencies to overreact to negative news or underreact to positive news, resulting in pricing discrepancies.

4. Calendar Abnormalities

Calendar anomalies are patterns in asset returns that are linked to specific calendar periods or events. Notable calendar anomalies include:

• January Effect: This is the tendency of stocks, especially small-cap ones, to yield higher returns in New Year i.e. January compared to other months. It was first introduced in 1942 by the Investment Banker Sidney B. Wachtel in his journal article “Certain Observations on Seasonal Movements in Stock Prices.”
• Weekend Effect: The weekend effect pertains to the observation that stock returns tend to be lower on Fridays and higher on Mondays. This effect is crucial for day traders who rely on it to predict where the market will move. It was first reported by Frank Cross in a 1973 article published in the Financial Analysts Journal. However, this continues to be a debated topic.
• Holiday Effect: The holiday effect signifies the inclination for stock prices to rise around holidays or during abbreviated trading weeks. Some investors become more risk-averse ahead of the holidays and use the time right before a holiday to sell off riskier stocks as a way to avoid any unexpected bad news that could happen while they’re away.

Cultural Influences on Financial Decisions

The financial world is not a one-size-fits-all domain. People from different countries have varying levels of comfort with risk and regret. Trust levels differ as well, making it prudent for financial advisers to keep their clients’ countries of origin in consideration when educating and advising them. Attempting to navigate the global financial arena without an understanding of these cultural differences is thus likely to yield ineffective, if not inaccurate, financial judgments.

• Savings Rate: Different cultures shape different saving attitudes in people. While many Asian societies encourage frugal spending and emphasise saving a big portion of their earnings for the future due to previous experiences with poverty and economic instability, immediate consumption often takes precedence over saving in the more consumerist societies. Such cultural differences naturally and quite directly affect people’s financial decisions by influencing the amount of funds they have available for investing.
• Asset Class Preferences: Cultural variables also influence the asset classes preferred by individuals for investment. For instance, homeownership is generally associated with personal and societal success in Western countries, and is viewed almost like a right of passage, causing many to prioritise investing in real estate. Gold, on the other hand, is highly valued in countries like India and China due to its important role in societal rituals and its recognition as a status symbol.
• Time Horizon: Investment decisions are often closely tied to cultural milestones. People save for education, marriage, or retirement. Since cultural factors influence when these events occur, culture has a substantial impact on the investment time horizon, that is, culture influences the period of time one expects to hold an investment until they need the money back.
• Superstitions: Despite not making much sense when viewed from a purely logical perspective, cultural superstitions do play a role in influencing investment decisions in a region. For instance, in India, some days are considered lucky for making big purchases, causing a visible spike in asset purchases on those days.

The bottom line : Cultural factors can and do have a significant impact on financial decision making. Human beings, who are cultural beings by definition, view and navigate the financial world as they do any other world- through a cultural lens and thus, cultural forces are always silently in play, whether we know it or not.

Exploring Behavioral Finance’s Perspective on the Efficient Market Hypothesis

The Efficient Market Hypothesis is a widely discussed and debated theory in the realm of traditional finance. According to the EMH, the prices of financial assets accurately reflect all information accessible at any given time. It holds that stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks at inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments. Efficient markets “do not allow investors to earn above-average returns without accepting above-average risks” (Malkiel, 2003 ). In Malkiel’s (2003) terms, “the accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay”. In other words, the EMH suggests that financial markets instantaneously incorporate new information making it impossible to consistently outperform the market through stock selection or market timing because all relevant information is already reflected in the stock prices. Considered the backbone of contemporary financial theory, the EMH was first proposed by Eugene Fama in his 1965 paper “The Behavior of Stock Market Prices.” But the theory existed long before that, Fama is the first one to clearly outline the EMH in three forms: weak, semi-strong, and strong. Decades ago, the efficient market hypothesis was widely accepted by all financial economists who believed that securities markets are extremely efficient in reflecting information about stock prices. The efficient markets theory reached the height of its dominance in academic circles around the 1970s. By the start of the 21st century, however, faith in efficient market hypothesis had started eroding due to discoveries of anomalies and the subsequent emergence of behavioural finance as a discipline. At the heart of EMH is the assumption of rational investors. EMH asserts that market participants make decisions solely based on available information and in their best economic interest. However, Behavioral Finance argues that this assumption doesn’t always hold in the real world. Anchoring bias, loss aversion, herd mentality, heuristic simplification, and overconfidence—all discussed earlier—highlight how human behaviour often deviates from the rationality assumed by EMH. Many experts started to believe that stock prices may be predictable, at least to some extent. Thaler and Barberis (2003) considered “deviations in rational behaviour as something intrinsic to human nature” and that must be incorporated into economic analysis as a natural extension of traditional models. Some of the most important studies in the area of behavioural finance show that in an economy in which rational and irrational agents interact, irrationality can significantly influence asset prices. The need for the interplay between behavioural finance and EMH arises due to the complex nature of financial markets. While EMH provides a theoretical framework for market efficiency, behavioural financial concepts shed light on the very real influence of human psychology on financial decision-making. Recognizing these biases is essential for investors and market participants, as it facilitates a more nuanced and comprehensive view of market dynamics, one that acknowledges both the rational and irrational aspects of financial behaviour.

How does Knowing about Behavioral Finance Help?

Individuals and organisations make use of the concepts of behavioural finance to make decisions that are suitable and likeable to all. Below are some applications of behavioural finance :

1. Retirement Planning

Individuals often struggle to save enough for their retirement because they tend to underestimate how much they will need. Having an in-depth understanding of behavioural finance helps them save better by providing them realistic goals for their future.

2. Corporate Finance

In the realm of corporate finance, behavioural finance helps companies use insights to design better incentive systems for their employees taking into account the way they would react to various rewards and punishments.

3. Public Policy

Behavioural finance insights are used by policy officials to design better policies that evaluate how people operate and behave financially. They try to frame policies that will be best received by the masses.

4. Investing

By understanding the insights of behavioural finance, investors can understand their own biases and emotional influences. They can make more informed decisions about what to buy and when to sell. This is helpful in avoiding common mistakes.

5. Financial Advising

Financial advisors can leverage insights from behavioural finance to assist their clients in improving their financial decision-making. By comprehending the biases and emotional factors that can affect decision-making, advisors can guide clients in steering clear of typical mistakes and making well-informed choices. Using insights from behavioural finance offers numerous advantages in financial decision-making. Firstly, it leads to more accurate models by acknowledging that people don’t always act rationally or in their best interests. This improves the realism of financial models. Additionally, it enhances decision-making by addressing biases and emotional influences, enabling individuals and organisations to make more informed choices and avoid errors. It also aids in risk management, allowing for better strategies to mitigate various risks. Additionally, it improves financial communication by understanding how people interpret information. Moreover, it fosters empathy and understanding of others’ perspectives, helping collaboration toward shared objectives.

How to Overcome Behavioral Finance Issues?

While there is no infallible method to escape the negative effects caused by behavioural finance but investors can try the following strategies that can guard against bias :

• Do Not Run Behind Yesterday’s Winners Past performance by somebody in the realm of investing might mislead one because it is not a guarantee of future performance. “Performance chasing” witnesses money flowing into recent winners and away from recent losers. Thus, one must not expect recent success to continue in the long-run as well.
• Seek Contrary Opinions Investors are vulnerable to confirmation bias, as far too many investors seek validation from sources that support their investment thesis, while avoiding opposing points of view. The best investors seek contrarian opinions, then evaluate the strengths of the competing arguments.
• Prefer Reflective Decision Making to Reflexive Decision Making Reflexive decision making implies ‘going with your gut’. It is an effortless and instinctive way of taking decisions. On the other hand, reflective decision making refers to the application of logic and reasoning before making any decision. Relying on reflexive decision making makes us prone to emotional and social influences. Thus, an investor must establish a logical decision making process by research and analysis from authentic data and sources.

The Bottom Line

All of us have cognitive biases and emotions that are deeply-ingrained biases within our psyche. While they may occasionally be helpful in our everyday lives, they can have quite the opposite effect when it comes to investing, often resulting in decisions that are less than ideal. Acknowledging their presence can however allow us to stay on top of them and empower us to be aware, open-minded individuals capable of making financially sound decisions. Thus, through knowledge of behavioural finance, we can not only get a more comprehensive view of how financial markets work but also gain a better understanding of investor behaviour.

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