Home ›› 23 Oct 2022 ›› Special Supplement
Traditional finance or standard finance assumes that investors are rational and homo economicus while making investment decisions. It also assumes that the market is efficient, investors have self-control, and not confused by cognitive errors.
In reality, however, most of the people are not rational. To explain this anomaly, behavioral finance comes in. Behavioral finance studies the effects of psychology on investors’ minds and financial markets.
It focuses on explaining why investors lack self-control and investors work against their own best interest, taking decisions based on personal biases, heuristic methods, and falling in bounded rationality.
Professor Richard Thaler, who received the Nobel Memorial Prize in Economic Sciences in 2017 for his contributions to behavioral economics, is considered the founding father of behavioral finance.
Behavioral finance at its core identifies and explains the inefficiency and mispricing in the financial market. It uses experiments and research to explain that humans and financial markets are not always rational, and the decisions they make are often flawed.
Standard finance assumes that the market is efficient and they propose Efficient Market Hypothesis, a popular theory that the stock market moves in rational ways.
The proponents of behavioral finance, however, suggest heuristics and subconscious biases that cause the investors to be irrational while making investment decisions.
In the past decade, behavioral finance has been taken in the academic and financial communities as a subfield of behavioral economics influenced by economic psychology. It shows how, when and why behavior deviates from rational expectations. As a result, behavioral finance provides a guideline to help investors to make better decisions.
Understanding Behavioral Finance
The proponents of behavioral finance suggest that Investors are not rational, rather normal, and they lack self-control influenced by their own biases. Moreover, investors make cognitive errors, for which they make wrong decisions.
Researchers of behavioral finance use psychology and economics to explore why people sometimes make emotional rather than logical decisions, and why their behavior does not follow accepted economic models.
Behavioral economics has also identified systematic errors and biases happening on a regular basis under certain circumstances.
Hence, behavioral finance offers a framework to understand when and how people make mistakes. There are two types of human behaviors that factor heavily in behavioral economics – heuristics and biases.
Understanding Financial Heuristics
Behavioral economists suggest that people use the heuristics approach when they deal with a complex decision. Heuristics are mental shortcuts we use to decide something quickly. It is also called the rule of thumb developed over the years within someone based on experience.
Investors and financial professionals often use heuristics when analysing investment decisions. As Heuristics are often based on rules of thumb or shortcut process of information processing, heuristics approach may not always be right.
To make it more clear let us have an example about heuristic approach. An investor decided to invest Tk 8,000 in the stock market in January 2021. Six months later, the stocks he had purchased were down by 50 per cent.
However, in the year end, the stocks he had purchased went up by 75 per cent from the dip. In the heuristics approach, rule of thumb, may suggest that the investor made profit as it jumps by 75 per cent, but in reality the investor is still in loss from his initial investment of TK 8,000.
Hence, it is risky to use mental shortcuts or rule of thumb while making investment decisions.
Another example of a common heuristic is that the past investment performance indicates future returns. Although it could be, it does not consider an unexpected change in the economy because of Covid 19 or Russia-Ukraine war.
Moreover, the mutual fund which was performing better in the last five years, may not perform well in the future because of changes in the management or high inflation induced by increased energy prices that impacted the financial market.
Understanding Behavioral Finance biases
Apart from the heuristics approach, there are many biases that lead to wrong investment decisions.
This is because in this fast information age, high volumes of simultaneous corporate news impose cognitive and emotional load on investors, especially amateur investors, causing them to overlook possibly relevant news.
An investor, because of situational pressure and surrounding environment, relies on biases that he or she can hardly differentiate at the spur of the moment. Greed also plays an important role in these biases. The most common biases are as follows.
Overconfidence bias
Investors and market analysts presume that they are highly skilled and above average in their analytical skill because of experience and qualification. However, it is obviously impossible for investors and analysts to be above average.
This is also a prevailing issue in Bangladesh’s capital market.
Confirmation bias
This is a very common bias among the people regardless of investment decision. We like to pay attention to the information that confirms our belief. We ignore information that contradicts our belief.
Because of this bias, we limit our ability, which hinders the process of making rational investment decisions. The confirmation bias is heavily practiced in our capital market.
Framing bias
An issue can be presented both the positive or negative way based on available information. Framing bias occurs when people make a decision based on the way the information is presented, as opposed to facts.
For example, Sri Lanka went bankrupt because they failed to perform debt servicing. It will be a framing bias to consider that just because Bangladesh has debt, we are also going to be like Sri Lanka soon.
But if we analyse that our external debt to GDP is less than 30 per cent, it is manageable and we have a solid macro-economy base, then the decision making process will be different.
Self-attribution bias
Taking self-credit when there is a good investment return, makes us believe that we made the best decision. On the other hand, when something bad happens in the returns, we attribute it to sheer bad luck. In our country, we also blame not only bad luck, but also the regulators and issue managers.
Hindsight bias
Hindsight bias can widely be seen in our society. It is a mentality of “I knew it before.” Someone may also mistakenly assume that they possess special talent in predicting an outcome.
Narrative Fallacy bias
This bias stops us from thinking objectively or in a neutral way. We love stories, and we let our preference for a good story avoid real facts, objective analysis. Hence, we are prone to good stories rather than real facts while making rational decisions.
It means that we make wrong decisions by following a better story.
Representativeness bias
It is very common in our capital market. People frequently make the mistake of believing that two similar things or events are more closely correlated than they actually are.
For instance, if the share price of Square Pharma increases, that of the big cap companies will increase as well. However, this may not be the case or a rational way of thinking.
Anchoring bias
This bias is about sticking to the first impression of something. Anchoring bias occurs when people rely too much on pre-existing information when making decisions.
Loss aversion bias
Investors avoid potential loss-making decisions. If an investment incurs losses in the first phase, but brings profit in the future, investors will hardly choose the project or investment.
Research on loss aversion shows that investors feel the pain of a loss more than twice as strongly compared to the enjoyment of making a profit.
Herd Mentality bias
We are more or less familiar with this bias. Herd mentality bias refers to investors’ tendency to follow what other investors are doing. They are largely influenced by emotion and instinct rather than by their own independent analysis.
Behavioral Finance, a growing field
Behavioral finance has been developing for around 40 years against the reasoning of the standard finance. Meir Statman wrote a book on Behavioral Finance explaining the second generation thought on the matter.
Yale Professor Robert Shiller, who received the Nobel Memorial Prize in Economic Sciences in 2013, termed Efficient Market Hypothesis as half-true. Hence, behavioral finance is finding its place strongly in the field of finance.
Financial analysts, asset managers and investors can seriously consider it while making investment decisions.
Behavioral finance teaches us ways to overcome biases and cognitive errors in relation to investing. It suggests a process involving logical and methodical analysis, which requires effort to engage actively, not merely focusing on the outcome.
For this, investors need to have pre-planning, commitment and mental discipline.
The legendary investor Warren Buffett once said that investing success does not correlate with IQ after you are above a score of 25, and once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.
Mahbub H Mazumdar FCMA is the chief executive of AFC Capital Ltd, while Mohammad Jasim Uddin, MBA, MPF is the chief investment officer at Athena Venture & Equities Ltd.
