February 12, 2017    4 minute read

Let’s Stop Pretending That People Are Rational

Behavioural Finance    February 12, 2017    4 minute read

Let’s Stop Pretending That People Are Rational

Why are investors infrequently shuffling their portfolio and why is this portfolio not diversified enough? How does one explain the gap in performance between equities and government bonds, which is sometimes obvious in the markets? Why does the dynamics of asset prices seem to be somehow predictable in specific time frames? How does one explain the episodes of market seasonability or the phenomenon of under-reaction to important news?

Empirical evidence has shown that investors do not behave, in most cases, in a rational way. So how can one study their behaviour? Behavioural finance theory rejects the efficiency of markets and, consequently, the idea that economic agents are perfectly rational and, therefore, carry out independent choices (as Keynes said: “People prefer to fail conventionally than to succeed unconventionally”). They also reject that arbitrage is capable of neutralising the price impact made by related irrational investors.

Behavioral Finance

Behavioural finance is the discipline that aims to integrate the financial theories with the latest research on how people interpret information to make a decision in the field of economics and finance. The basic assumption of this matter is that, contrary to what is taught by basic microeconomics, a man does not make rational choices but is influenced by emotional bias, cognitive bias and process bias.

A bias is, in short, detrimental to the subject in question, leading them to draw conclusions not always supported by facts. Numerous studies have shown that people tend to display selective perception, which tends to focus on information that supports a preconceived idea and to overlook information that contradicts it.

In addition, the innate human tendency to conform to a group’s choices leads inevitably to making investments inconsistent with the actual needs of the individual investor. Behavioural finance has shown that investors fear the losses more than they appreciate the gains and that a significant loss leaves a “mark” in the customer’s memory sharper than that of an equal value gain.

The Negative Pattern

This leads to a pattern of reasoning that is outlined as follows: investments making losses are held for too long (according to the thought: “I will not sell at a loss because I expect a recovery”) while rewarding investments are sold too soon, leading to regrets regarding having sold at the wrong time.

Not only that, but behavioural finance has also shown that the more a scenario is representative of what one already has in mind, the more one thinks the probability it will happen is higher, leading to a clear case of cognitive distortion.

This means that the classic value curve changes as below. The study of this topic won the Nobel Prize for economics for Daniel Kahneman and Vernon L. Smith in 2002 for their “identification of laboratory tests as a tool for empirical economic analysis, especially in the functioning of alternative markets study”. The graph below is the value curve that they elaborated.

13390dfb82a42f38116a33c9eed75eba

A particularly significant example of irrational behaviour can be this one: a coin is tossed six times. Six times comes out “head”, the question therefore is: the seventh time will come “heads or tails”? Instinctively one would tend to say “cross” but the homo economicus, applying statistics, should always choose “indifferent” because regardless of previous launches the probability is always 50% and 50%. In extreme, synthesis studies on behavioural finance have reported, among many other results, that the investors’ behaviour follows the trend shown in the graph below.cycle-of-investor-emotions

The average tendency to buy and sell certain stocks at the same time and to concentrate purchases in upturns and sales in downturns produces practical effects on markets such as creating speculative bubbles and changes in bond yield.

In fact, on average, assets purchased in bulk tend to have a high immediate return, and those subject to massive sales seem to generate high performance in the six months following the operation.

Conclusion

A lot could be said about behavioural finance, especially if one thinks that it is still not taught to students in many business schools. As Bloomberg reported, “no introductory finance course would be complete without them. In addition to identifying anomalies in prices, behavioural finance has found that individual investors suffer from a large number of biases and that their wealth suffers as a result.

That is a finding that directly affects the pocketbooks of millions of people. So next time some macroeconomist tells you that behavioural economics is passe, tell them that behavioural finance is alive and well.”

Get articles like this straight to your inbox each morning with our Breakfast Briefing. Sign up by clicking here!

Log in with your details

or    

Forgot your details?

Create Account

Send this to friend