Behavioural finance analyses and identifies the emotional biases that influence investment decision making.
Faced with different situations in the financial markets, and due to our human condition, decisions are made that in many cases are not rational enough and are components of emotional behaviour. These emotional components influence us significantly and can condition us in an inadequate way.
For example, investors are willing to strongly buy when market expectations seem to be favourable and strongly sell when there is some uncertainty about the future. Excessive enthusiasm or fear, and the contagion of behaviour that occurs in financial markets through the imitation effect, can lead to an overvaluation or undervaluation of certain assets at specific times and even over longer periods of time.
The ability to understand and identify these types of behavioural biases will help us, although it is not easy, to avoid decisions resulting from the non-rational or impulsive nature of the moment.
In my classes in the United States, on Financial Markets and Portfolio Management courses, with highly qualified students, as an introduction to Behavioural Finance, I always performed the experiment of choosing the scenario with the highest probability, “heads or tails”, when I flipped a coin in the air, knowing that the previous 5 times the result had been tails. What would you answer?
The vast majority of students chose “heads”. Even I felt the irrational temptation to choose the same. The rational answer would be that there is the same probability of landing on heads and tails, since, statistically, this is an experiment of independent events. When we repeat over and over again this experiment of throwing a coin up in the air, the probability will always be 50% for each of the two possible options, unless it is a trick coin.
It is very important to understand and identify these biases when making an investment decision. Let’s look at some examples of some of the most common cognitive biases in investments:
This bias is the tendency for an individual to imitate the actions of a larger group, without taking into account their own personal opinion, even when that personal opinion is well informed to the contrary.
This behaviour is due to the social pressure of conformity and also the thought that it is unlikely for a large group of people to be wrong. When we do not act in this way we have a cognitive dissonance that makes us doubt our rational perception.
In financial markets, herd behaviour occurs very frequently.
In bull markets, the consequence is, as mentioned at the beginning of the article, a tendency to overvalue a particular asset or even the market as a whole. This contagion of excessive group optimism can also lead to financial bubbles. The subsequent adjustment of the market brings us back to reality, with the consequent damage especially to non-professional investors.
Something similar happens in bear markets, leading financial markets to excessive pessimism or caution in the face of uncertainty that in many cases does not correspond to the size of the falls. The very falls themselves, induced by such group behaviour, then provoke further fear in the financial markets. Once again, the hardest hit are individual investors who have not exited in time and have been caught up in those financial market falls.
Today we can observe another phenomenon that is the consequence of herd behaviour. This new phenomenon consists of the tendency to copy other investors in investment platforms with so-called “social trading” without the basis of rigorous analysis of the asset or product and its suitability for our investment profile.
The bias of the gambler’s fallacy is based on an individual mistakenly believing that an event occurs after one or more particular events that have no rational basis beyond beliefs and, in some cases, particular superstitions.
The example of the coin toss we described previously would be an example.
It is very interesting to note what happens with this type of belief when it is spread throughout the market. After a day of three or four consecutive days of increases in a financial asset, a day of decline in price is expected the following day.
There is also a belief that the assets have highest and lowest prices and they move solely in this range. This type of belief causes this type of prediction to come true in many cases, not on a rational basis, but because this belief spreads throughout the market.
The analysis of these investor behaviours and the patterns that are created is one of the fundamentals of technical analysis and chartism.
Something quite different, and which we can consider as another example of the gambler’s fallacy, is when investors starting out in investment who have learned a few rules on courses of dubious rigour, believe they are able to predict, in the short term, the price behaviour of an asset. Some of these investors also believe in certain rules that they discovered themselves and that they consider to be the magic formula for making money in financial markets.
This phenomenon occurs when the investor tends to attribute their successes to their own merits, and interprets accidental success as if it were the result of their personal skill, while failures are interpreted as bad luck.
The risk of this bias is the tendency to believe that they have sufficient knowledge and experience to predict the future and be able to “operate” in financial markets with false security.
This cognitive bias occurs when the investor is only seeking data or evidence that can justify a decision already made and that validates their preconceived idea.
This bias causes us to only seek information that justifies what we think and to reject such information that differs from our perception.
This bias causes us to become obsessed with a preconceived idea without contemplating other visions that may be more appropriate.
This deals with trying to justify a certain action, in many cases a consequence of impulsivity, with which we then have doubts about our decision.
We try to reduce the uneasiness caused by this decision, which goes against a rational principle, through the conformity of another person or by seeking partial information or new information purposefully sought to reduce this internal dissonance.
Accepting mistakes is key to learning how to make good decisions.
Investors, with the same information available, tend to invest in financial assets that they find more familiar or popular, even if there is no reason to think that they will behave better.
The search for and analysis of other investment options is one of the activities that brings more value to an investor and leads to a reduction in the overall risk of their portfolio due to the diversification effect.
The investor tends to make use of rules that are “too simple” in decision-making which are also linked to overconfidence. It is very normal in human behaviour to simplify or seek the simplest rules possible in order to make decisions. As human beings we try to reduce uncertainty by seeking certain cause-effect rules and this is even more so in the unpredictability of financial markets.
When we want to make investment decisions in the financial markets it is very risky when we simplify too much. With only a few calculations, ratios or indicators it is very difficult to assess an investment opportunity.
Any decision we make in our lives has a psychological component and, consequently, an investment decision will also be subject to bias. In the particular case of financial investments, the impact is of great significance as we may be putting our savings at risk.
The control of the biases produced by emotions, by understanding and identifying them, is fundamental to investing in financial markets.
Did you like it? Share with your friends: