Too many investment theories and concepts appear logical at face value, but their application presents difficulties that prevent optimal return for investors. The study of behavioural finance has blossomed in the past 15 years apparently as a result of attempts to explain how emotive factors and human psychology affect the way financial decision-making is carried out. In fact, the most difficult aspect of successful investing deals with managing human emotions and the errors and biases those emotions can engender.
Biases of judgement and decision-making have often been referred to as cognitive illusions and therefore, relying on one's intuitive reasoning will be insufficient in preventing the pitfalls of such illusions. The aim of learning about cognitive illusions is not only to develop a sense of awareness of situations, but to also supplement such awareness with critical and/or analytical reasoning.
Decision-theorists believe that significant decisions can be described as choices between gambles whose probabilities of outcomes are not fully known in advance. In our particular context, investors make judgments about such probabilities, assign values to the outcomes and finally combine these beliefs and values in forming preferences about risky options. It therefore goes to show that decision-making can be systematically wrong due to influences by biases, or by errors of preference.
Overconfidence is one such bias that impacts investors' decision-making. There exists a human tendency towards overconfidence in one's abilities and knowledge. Studies have found that 95% of a sample population would invariably place their ability to get along with people above the 50th percentile (i.e. above-average). It is imperative therefore; that decision-makers should always think of uncertain quantities in terms of confidence intervals, rather than best guesses.
Another powerful bias can be found in one's beliefs which are skewed towards optimism and the fact that optimists exaggerate their talents, provide evidence this bias has asymmetric impact on investors' judgements. Moreover, optimists also underestimate the likelihood of bad outcomes over which they have little control and underestimate the role of chance in human affairs.
Investors also tend to perceive systematic patterns in random sequences of events. Our tendency to adopt a hypothesis that causal factors may be at work also causes biases. In fact, studies clearly show that investors tend to overreact to random information by churning their portfolios. More startling are studies, which prove stocks sold by investors tend to outperform stocks purchased as their replacements by 3.4% points within a year of their sale.
Likewise, assigning a disproportionate weight to initial information received also engenders a bias in investors' decision-making. The so-called "anchor effect" may go some way in explaining why there still exist reluctance in some quarters regarding investing in emerging markets stocks given their past views on risk.
Preference errors also play a significant role in shaping investors' decision-making. Framing investment decisions in broad (wealth terms) or narrow (gains or losses) terms leads to different preferences. In fact, Daniel Kahneman and Amos Tversky's 'Prospect Theory: An Analysis of Decisions Under Risks' showed that decision-makers frame their decisions narrowly, often focusing on changes in gains or losses, and develop aversions to losses stemming from such changes. Decision-making premised upon an investor's loss aversion is termed the "prospect theory". This theory postulates that individuals maximize an S-shaped valuation function that is concave in regard to gains and conversely, convex in regard to losses. The diagram above highlights just such a relationship.
The prospect theory also stipulates that the convexity is steeper in the domain of losses than in the concavity found in the domain of gains. Depending on the current valuation of an investment, either the steeper convex domain of losses or the concave domain of gains will dominate an investor's decision-making. Typically, should current investment valuation be above an investor's reference point (i.e. falls on the concave domain), then according to the prospect theory, the investor would be more willing to sell the investment and realize the gains. In fact, studies of transaction records of individual investors (Terence Odean 'Are Investors Reluctant to Realize Their Losses' - Journal of Finance 1998) reveal exactly just that - marginal increments in an investment's valuation tend to induce investors to sell.
Hersh Shefrin and Meir Statman ('Disposition to Sell Winners Too Early and Ride Losers Too Long' -Journal of Finance 1985) applied the prospect theory in a broader investment perspective and called it "the disposition effect". An extension of the prospect theory, the disposition effect refers to a marked reluctance of investors to realize losses (loss aversion). It stipulates that investors evaluate their sell or hold investment decisions in terms of gains or losses and the expected-risk-return measure that were previously used for their investments. Key to such decisions is reference points to which gains or losses can be calculated. Typically, previous purchase or investment prices form such reference points but studies have proven that such points need not be fixed. Expectation or aspiration levels can also form reference points as well.
According to the prospect theory, if investors believe that risks associated with a particular investment no longer justify the returns, and then a decision will be made according to the S-shaped valuation function. In fact, investors' loss aversion can also be easily illustrated in the diagram above. As previously mentioned, the S-shaped curve is steeper in the domain of losses as declines in investment values correspond with larger declines in the derived value function. Simply put, an investor at point B in the graph would most likely risk marginal losses in the hope of obtaining potentially large gains.
Equally important is the fact that the graph also indicates clearly the near proportionality of risk attitudes that plague investors' decision-making (i.e. too little tolerance for risks with marginal gambles and far too much risk-taking with larger gambles). All said, the common fixation on an investment's purchase price, as a reference point and its consequent disposition effect, are prime examples of narrow decision frames that lead to errors of preference that ultimately affect investors' decision-making.
The above discussion illustrates that there are many factors affecting financial decision-making and the irrationality of such decision-making ensures the limitations of financial theories based on finite assumptions. Behavioural finance however, makes no such assumptions. It attempts to understand the psychological traits that affect decision-making.
The major consequence to these findings is that markets should be viewed as inefficient. Equity markets are complex social systems with positive feedback loops. Decisions of the participants are taken in an evolutionary way which leads to trends. These trends can deviate substantially from fair values calculated from neo-classical models. In practice this means that the analysis of price trends and particularly trends of relative strength is an important tool for security selection. LGT has successfully applied such methods in managing a global equity fund since 1999. The fund continues to rank in the top decile over most time periods. Another fund that uses behavioural finance is LGT's recently launched Global Active Timer. It is an innovative actively managed global equity fund that can invest fully in equities and/or hold a portion in cash. Relying on a holistic approach that combines fundamental macroeconomic analyses and technical analyses, the manager can make decisions regarding the proportion to be invested (active market timing) and stock selection (active security selection). In summary, behavioural finance, as strategy in financial markets, gives fundamental insights into systematic human patterns of decision making under uncertainty and time pressure and opens opportunities for successful investment.
