Despite investments and capital markets being structured and defined with mathematics, mathematical theories alone are not sufficient to predict future movements in price [which are without exception, expressed numerically]. This idea should be troubling. Despite consistent advancement in statistics and financial mathematics (ranging from computational probability algorithms to the Capital Asset Pricing Model and Efficiency Frontier theory), there is often an event or result in investment that is either inexplicable with mathematics means or stands in direct contrast with mathematical precepts. The reason for this phenomena is much less grandiose than the mathematical theories which attempt to explain it. The reason is us- humans. We are emotional beings and our decisions are seldom the result of objective calculation.
The Efficient Market Hypothesis (EMH) is the idea that all available information is fully reflected in the price of an asset, such as a stock. Developed in the 1960s by American economist Eugene Fama, the EMH argues that it is impossible for investors to consistently outperform the market as stocks always trade at their fair value. According to EMH all information is already priced in to asset prices and as such there is no way to outperform the market, because the markets appraisal of value via price is always correct and absolute. This is a controversial theory and underlies the ongoing debate between Active Vs. Passive investment strategies. The ability of some investment managers to consistently outperform the market, along with ‘irrational’ price movements in markets would implicate the existence of another, larger force at play. At this point many market participants looked to Behavioral Science and concurrently “Behavioral Finance” as yet another filter through which to view financial markets and explain changes in price, void of mathematics.
When looking at behaviour we will often reference Heuristics, which can be defined as the process by which people find things out for themselves usually by trial and error. Through Heuristics we are able to add another dimension of analysis to investment markets and performance. Heuristics is able to add colour to the irrational price movements that canonical mathematics deems to be fantastically improbable, or at times, impossible. To better understand your own cognitive biases, which at some level have been influencing your investment decisions let us cite an example.
Imagine you are introduced to Linda. Linda is 31, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and also participated in anti-nuclear demonstrations. Is she more likely to be:
- A bank employee?
- A bank employee and active in the feminist movement?
By the logic of probability there is a greater chance that Linda is a bank teller than the much smaller group of bank tellers who are also active in the feminist movement.
However, in a study by Tversky and Kahneman, this did not stop 85% of respondents thinking she was more likely to belong to this much smaller group, than the larger, more inclusive, group. Because of stereotypes, option (b) feels more representative of Linda even though it can never be more likely mathematically. This is the Representativeness Bias in action.
Prospect Theory and investment mistakes
You may currently be a victim of the following biases or at least remember a previous investment decision which could be explained by them. Prospect Theory attempts to describe and explain the states of mind that are often evidenced within individuals’ decision making processes under uncertainty. Being aware of them will enable you to build a robust portfolio.
Use of information
Investors may not take into account all relevant information. The idea of “relevance” itself is problematic, depending on the investment methodology being employed, e.g fundamental Vs. technical analysis. This bias is evident in the over-reliance upon past performance, often with the tendency to fail to fully account for future possibilities and contemporary influences of future returns.
Investors may base their decisions on reference points that are arbitrarily chosen; this can be simply explained as the preoccupation with what somebody used to have and what they might have had had their choices been different compared to what they have now. This idea commonly manifests when an investor holds onto shares because they are currently worth less than they paid for them as selling them would result in a loss, receiving less money back. Anchoring and loss aversion are macabre partners.
When people make decisions, they commonly leave them unchanged. Status quo bias is the resulting inertia commonly seen in circumstances of too much complexity; investors are scared into inactivity as the prospect of making a decision and dealing with the consequences of their decisions are more daunting than making no decisions, and leaving it to outside factors- the market.
Investors tend to overweight memorable facts and evidence. If you have recently read an article expounding the growth prospects of emerging market currency, it will probably cross your mind again if you are sitting down tomorrow to build a new portfolio. We are fickle and the way we process information is subject to a bias of positive recency.
Nobody likes making mistakes. Especially painful ones that cost money. Regret aversion arises from the desire to avoid pain from the result of a poor investment decision. This too will often be seen alongside anchoring whereby an investor will hold onto a poor investment as it continues to be worth less than they paid for it and to sell that investment would realize a loss. Regret aversion can also bias new investment decisions as people are often less willing to invest into markets or instruments in which they have already had a negative experience or loss. This will often have a larger cognitive weighting than any new, positive information that would otherwise make the investment seem like a good prospect.
People play it safe when protecting gains, but are reluctant to realize losses. This is painfully common among retail investors.
Behavioral finance has challenged the standard economic assumption that individuals treat types of income and wealth equally. For example, an investor may prefer to invest their own pension contributions as safely as possible, while they may look to take on more risk when investing an employer contribution. Risk appetite is also largely relative to the resources of the investor. A man with 1,000,000 USD invests 10,000 USD differently to the man who is investing the same sum, with a total asset base of only 20,000 USD. The interplay of current availability of money and likelihood of recouping the same sum via other means will dictate money’s worth and how it is accounted for mentally.
Much time has been spent compiling data and evidence to support the idea that markets are efficient and an equal amount of time has been spent looking at symmetrical evidence to the contrary. Markets participated in by people are inefficient- owing to humans being innately emotional and irrational. It is the balance between human and non-human market participants (automated trading strategies) and their respective degree of participation (volume) that will influence future financial theory in portfolio management. For the moment, you will do well to be aware of your own cognitive biases. Your finances depend upon it.