Tuesday, 01 October 2013 - 20:00

 

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Seed Weekly - Behavioural Finance and Investing

Standard finance theory proposes that all investors are rational in their seeking of returns and reduction of risk, i.e. the rational economic man, but many studies together with observations of actual behaviour reveal that time and time again investors are not as rational as standard finance theory would have us believe. This is because emotions and biases come into play.

For example psychological studies have demonstrated that the emotional “pain” of losing money from investments is nearly three times greater than the joy of earning money. Small market declines can quickly turn into panic selling, as nervous investors hate to experience short term price volatility even on longer term investments. In such cases, rationality goes out of the window and emotions take over.

Behavioural finance has therefore developed to study emotional and cognitive biases or errors that many investors bring to bear on their decision making.

Perhaps one of the most important works on behavioural finance was introduced by two cognitive psychologists, Amos Tversky and Daniel Kahneman, who began research on decision making under uncertainty. Their research paper, “Prospect Theory: An analysis of Decision under Risk.” was published in 1979. In essence prospect theory describes how individuals evaluate gains and losses.

The various biases can be divided into two main categories cognitive and emotional biases. Within these main categories some of the biases that have been identified include framing, overconfidence, illusion of control, availability, anchoring, mental accounting, optimism, and loss aversion.

One such cognitive bias is representativeness, which is a tool that the brain uses in order to rapidly classify information. It allows the brain to quickly process large amounts of data, but it remains a shortcut, which can often lead to erroneous thinking.

Example: You are given the following information:

Mary is quiet, studious and very concerned with social issues. While an undergraduate at Berkley, she majored in English Literature and Environmental Studies.

Given this information, indicate which one of the following 3 is most probable

1. Mary is a Librarian
2. Mary is a Librarian and a member of the London Literature Society
3. Mary works in the banking industry

The best answer is 3, because of the sheer number of the people working in the banking industry versus librarians and therefore it has the highest probability. Selecting 1, individuals are probably making a representativeness mistake, i.e. by assuming that Mary has traits of librarians (English major, quiet and studious), she is one. While many select choice 2, it cannot be because this is a subset of 1.

Investors often make mistakes with this shortcut.

o Attempting to determine the success of an investment in company A, by categorizing company A as a value share, and so drawing conclusions about risks and rewards from this simple classification.
o Assessing the probability of a successful outcome, using a sample of data and incorrectly assuming that the small set of data is representative of the total population of data.
o Assuming that shares with similar traits are likely to be identical, even though they may be quite different in reality.

With the vast scale of information that investors need to deal with, it is obvious that we so easily fall back on making representative biases in decision making. What is important is that we recognise this pitfall and try to take appropriate steps to reduce or avoid this bias.

Kind regards,

Ian de Lange

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 01 Oct 2013

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