Investment surgery
What is the Efficient Markets Hypothesis (EMH)?
No discussion of behavioural finance would be complete without consideration of the Efficient Markets Hypothesis (EMH) - the backbone of finance theory since the 1960s. In its simplest form, the EMH asserts that at any point in time everything known or knowable about the fundamental value of a stock should be factored into its price. In order to reach this conclusion, the EMH assumes that investors approach investment decision making rationally, objectively and with perfect cognisance. That is, they can source, sift through and perfectly interpret all salient information about a stock, no matter how that information is presented. Therefore, any new relevant information is quickly and correctly incorporated into stock prices, thereby rendering current and past stock prices and any other publicly available information already factored into prices of no predictive value to investors. Consequently, stock prices move in a random and unpredictable manner. That is, they follow a “random walk”.
What is behavioural finance?
Whilst it has always been known that investors do not approach investment decision making with perfect cognisance and in a well informed and perfectly rational manner, for simplicity it had been assumed that investors, on the whole, acted as if they did. Without a clear sense of knowing how and why investors deviated from the efficient markets model, it was difficult to articulate anything rigorous or distinctive about the way in which investment decision making and markets really worked. In recent years, however, this has changed as significant advances have been made in what has become known as behavioural finance.
Quite simply, behavioural finance is the fusing of traditional finance theory with psychology. In contrast to the EMH, rather than make simplifying assumptions about the way in which investors approach investment decision making, behavioural finance instead analyses the way in which cognitive bias repeatedly enters investors’ decision-making processes. In so doing, behavioural finance attempts to explain why stock prices frequently depart from their fundamental value and why trends and patterns, that are inconsistent with the EMH, frequently arise within financial markets.
Crucially behavioural finance accepts that the information used by investors when making investment decisions is far from perfect, the human mind is not a supercomputer and the world is an uncertain place. Moreover, a central tenet of behavioural finance is that there are very few quick learners amongst us. When approaching investment decision making, we repeat mistakes with alarming regularity, causing stock prices and markets to move in an unpredictable manner. Perhaps most importantly, behavioural finance, unlike the EMH, captures the social aspect of human behaviour – how we act in groups. Arguably within financial markets, rather than base decisions on their own information and opinions, many investors tend to rely on the actions and opinions of others, particularly those who they perceive to be “experts”. This is reinforced by the fact that there are very few independent thinkers amongst us. As social animals we find it difficult to stick to an opinion that differs markedly from the group. We also tend to prefer to have our actions and opinions validated by others.
In short, behavioural finance is a useful tool for observing how financial markets work in practice rather than theorising about how they should work.
Is behavioural finance a new phenomenon?
Behavioural finance is not a new science. Academics and market practitioners have been writing about the psychology of the market for some time. In fact, one of the earliest texts on the subject dates back to 1841. However, the modern day origins of behavioural finance lie in the late 1960s and 1970s when challenges to the EMH started to appear firstly in psychology journals and then key financial journals. When psychology professor Daniel Kahneman, one of the founding fathers and leading lights in the behavioural finance world, shared the Nobel Prize for Economics in 2002, behavioural finance was placed firmly in the limelight.
Why hasn’t behavioural finance become more mainstream?
Behavioural finance has certainly grown as both a research topic and in its practical application within the asset management industry in recent years. Indeed, very few fund managers would admit to not applying its vast and disparate array of phenomena to their investment processes. However, unlike the EMH, with its simple conceptual approach, no one has yet been able to consolidate what has become an extensive body of research, into a simple set of unifying principles. Basically, there is a need to tie together observations of human behaviour in such a way that would facilitate the modelling of how market prices move in aggregate and how profitable trading opportunities can be identified. Until then, the EMH and behavioural finance are likely to coexist as uncomfortable bedfellows.
Some of the more commonly cited behavioural biases are:
- Representativeness: subconsciously creating and extrapolating patterns and trends from a series of random events
- Availability: placing too much or too little emphasis on the likelihood of events occurring based on how salient they are
- Gamblers fallacy: confusing small samples of data with larger samples of the same population
- Overconfidence: an overestimation of one’s own knowledge, skill and ability, resulting in undiversified portfolios and excessive portfolio turnover to the detriment of investment returns
- Adjustment conservatism: being overconfident in one’s own forecasting ability and so failing to adjust forecasts for new salient news
- Anchoring: placing too much emphasis on irrelevant facts and figures, eg the price paid for a stock, when considering the stock’s future prospects
- Ambiguity aversion: a preference for known, rather than unknown, risks which results in a home bias to portfolios
- Loss aversion: a dominant motivation to avoid losses causing investors to sell their top performing investments too soon and hold on to their loss making investments too long
