Behavioural finance offers the prospect of a better understanding of financial markets as well as scope for advisers and their clients to make better investment decisions, explains Ryan Paterson
"The investor's chief problem - and even his worst enemy - is likely to be himself."
Traditional finance is based on rational and logical theories, such as the capital asset pricing model (a model that describes the relationship between market risk and expected return for assets) and the efficient market hypothesis (a theory in financial economics that states an asset's price fully reflects all available information).
These theories assume investors are rational, which means they make decisions that maximise utility and revise their expectations in a manner consistent with Bayes' formula (updated probabilities based on new information). In addition, it is assumed investors are both self-interested and risk-averse.
Behavioural finance on the other hand is focused on explaining why market participants make irrational systematic errors contrary to the assumption of rational market participants. In other words, behavioural finance differs from traditional finance in that it focuses on how investors and markets behave in practice rather than in theory.
Behavioural biases can be categorised as cognitive errors or emotional biases. Cognitive errors are glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions. Emotional biases meanwhile relate to feelings or beliefs that may or may not be reality-formed - this bias is much more difficult to control.
Cognitive errors can be classified in two categories. The first contains ‘belief perseverance' biases, which suggest that, when faced with evidence that contradicts our beliefs, we choose to discredit, misinterpret, or place little significance on the contradictory information.
Investors exhibiting ‘confirmation bias', for example, have a tendency to search for, interpret, favour and recall information in a way that confirms their existing opinions. The result is a one-sided view of the situation and helps explain why bulls tend to remain bullish and bears tend to remain bearish.
Placing excessive weight on confirmatory information after making an investment decision and ignoring or modifying contradictory information can lead to poor financial decision-making.
Investors need to be aware confirmation bias is common among us all. Making a deliberate effort to gather and process both positive and negative data will help form better decisions and help moderate the bias.
The second category of cognitive errors deals with ‘processing errors' relating to the misusing and the irrational or wrongful processing of information to make decisions. One such error is ‘anchoring'.
This concept draws upon the tendency for us to anchor our thoughts around a reference point despite the fact it may have no logical relevance to the decision at hand. Investors influenced by this bias often become fixated on a particular level or round number, such as gold trading at $1,000 or oil at $50.
This is also true in relation to setting target prices or determining the economic condition of a country, even if the investing landscape has shifted or new information is available, which can lead to inappropriate investment decisions
Here, investors should question whether we are giving undue weight to an entry point, or some other state that has become the ‘anchor'. We should also remind ourselves that historical prices, market performance and previous reputation have little if no correlation with future investment potential.
Emotional biases are much harder to control because they originate from unconscious influences rather than conscious calculation. For that reason it may only be possible to recognise the bias and adapt to it rather than correct for it. Emotional biases are rarely identified and recorded in the decision-making process.
One example of emotional bias is ‘regret aversion'. When we resist taking action due to fear of bad outcomes, we usually suffer a regret aversion bias. This tendency is especially prevalent in investment decision-making and stems from the desire to avoid feeling responsible for poor results.
Regret bias has two dimensions that arise through errors of omission (a failure to act) or commission (an act). It is the regret from actions taken that generally create stronger feelings, which results in a lack of action as the default position.
If the investor does engage in financial markets, it is likely to result in herding behaviour as they feel safer in popular investments. If the investment does turn out to be a mistake, they can at least console themselves in that they were not the only one who got thing wrong!
In overcoming regret aversion, investors must come to terms with the fact losses happen to everyone and the long-term outcome should not be sacrificed to follow the current trend. Investors need to acknowledge the risk-reducing and return-enhancing advantages of diversification and the benefits of an appropriate asset allocation.
Behavioural finance holds out the prospect of a better understanding of financial markets and offers scope for investors to make better investment decisions based on an understanding of the potential pitfalls.
Human beings cannot cure our biases, but we can attempt to mitigate their effects. Using techniques such as feedback, audit trails for decisions, checklists and ‘devil's advocates' can help advisers and clients alike make decisions in a more rational manner.
Investors need to avoid the costly errors stemming from a quest for comfort that capital markets rarely reward and, by maintaining our discipline and staying committed to a long-term strategy, we improve our chances of investment success.
Ryan Paterson is a research analyst at Thesis Asset Management
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