Investing, Human Psychology, and Behavioural Biases – Is the Human Brain Fit For Purpose?
In today’s world of economics, the investment management industry is a reservoir of some of the best brains our generation can offer. Give these professionals a pound of your ear and you are certain to be dazzled by their brilliance. They are eloquent, articulate, and speak with conviction. They are just plainly smart, and we should give it to them.
But that is not where the story ends, in fact, that is where it starts. Does that smartness convert to being right all the time. No, is the answer. The question then becomes, how then are boards of trustees expected to engage with such exceptional talent, when that talent though does not always yield positive returns.
The answer maybe lies in seeking to understand the human brain – more specifically, the flaws of the human brain. Investment managers who understand their own flaws, and trustees who are alert to not only the flaws of the investment managers, but to their own too, make for a more effective and efficient industry.
Welcome then to the field of behavioural finance.
While still a fairly new discipline, the field has helped solve some of the more complex behavioural observations that conventional investment textbooks had struggled to explain. Anchored on the assumption that investment market participants are rational, utility-maximising, Homo Economicus, it is not surprising that these investment textbooks would have failed dismally to explain observable human behaviour. The truth is, investors are normal beings, Homo Sapiens, descendants of their cave tribesmen, who behave “normally”.
Found on the intersection of three disciplines – cognitive psychology, standard finance, and neurosciences, behavioural finance makes sense of what vexes theory-anchored conventional investment textbooks.
The Four Stratums of Behavioral Finance
While unpacking the principles of behavioural finance could be done in a variety of brilliant ways, we find our own four-stratum model to be exceptionally good at doing the job. With this model, behavioural finance is looked at as a four-layered hierarchical structure where cognitive biases form the foundations of the hierarchy. These are firmly ingrained in human DNA and are permanent influencers of our behaviour.
Sitting above the foundational layer of cognitive biases is sentiment. While not as ingrained as cognitive biases, sentiment is probably the biggest driver of all the volatility in the capital markets that cannot be explained through changes in the market fundamentals. For instance, it is sentiment that our own central bank attributes its failure to harness the spiraling exchange rate.
Sentiment can be positive or negative. When it is positive, and the market is awash with optimism, investors can enjoy riding the wave and benefit from the rewards that come with it. When it is negative, and there is utter pessimism everywhere then subpar performance, and below average returns, is all that the market can give. Whether it is on the rise or on the decline, sentiment-driven market episodes are hugely disconnected from the market fundamentals.
The next layer, sitting above the sentiment one, has its roots back to our times as cavemen – with its two mutually exclusive attributes of fear and greed. This layer is emotions-driven, and just like sentiment, may start and end with no links to the fundamentals at all.
Greed usually starts with a wave of hope sweeping through the markets that then slowly gives way to relief as more and more market participants start to believe that some positive change is on the horizon. With no fundamentals to back it at all, some start to take positions in the investment markets in preparation to ride the wave. Bring in the media, social or conventional, into the mix and the flame of hope glows brighter. Stories of how long overdue the market was for a rise start to be penned with conviction – even by those with little knowledge of how the investment markets work.
As if with a trigger, FOMO, “Fear Of Missing Out”, kicks in and an unstoppable “investment markets rush” speedily takes off. There is excitement all over as the market rises and everyone is riding the wave. Overnight millionaires are being made, at least on paper. It is thrilling as the wave continues rising, inviting more of those that were still on the sidelines. Suddenly, now everyone is an investment expert. Names of popular stocks are being thrown around, with some wishing they could bet even the whole house on their favourite stocks. The speculative behaviour only invites more speculation. One-time and two-time chancers now start to lecture on investments.
Unable to continue to rub-off the pressure, the last group joins in – this is your traditionally risk-averse individuals and entities who ordinarily would rather keep their money in cattle or gold form, or under a pillow. They are the last ones to partake in the euphoria. They jump in anticipation of even more rises, but then no one is coming in after them to keep fueling the flame with new dry powder. Suddenly the rate of price increases slows down, subsides, fades away, and prices ultimately stagnate. No more price increases and no more money to be made – the party is over.
As each of the market revellers realises that the radio has stopped playing, they dash for the exit door. In almost a similar fashion as that in which they came in, the investment market rush is replaced with “flight to safety”. Anxiety, panic, and desperation take centre stage. Everyone wants out – desperately so. Everyone is selling, and no one is buying. The more they cannot sell, the more they want to sell. They oversell. Prices plummet past those that would be dictated by fundamentals. Capitulation and despondency slides in. Hopelessness becomes visible as slowly, one-by-one, participants count their losses – unforgiving investment markets. One last look, and they quietly coil into depression – never again to allow themselves to be lectured on investment “opportunities”. But wait until another wave starts ……. and the cycle begins again – and that’s “investment management by emotions” for you.
The fourth and final layer of the hierarchy is mood. Of all the layers, this is the one with the shortest horizon. It can be as short as just a couple of hours or minutes. Like with the other three though, mood-driven market movements have no explanations in fundamentals at all. The Monday following a football match in which the national soccer team lost could be the reason why the stock market closes the day in the red. Or, an overly cloudy day could just be the only reason markets give pedestrian returns regardless of what the fundamentals could be dictating. In the West, before the world really became this villagised, and before their markets became significant destinations of Eastern capital flows, there was wisdom in entering their investment markets in winter as then the prices would generally be subdued.
Cognitive Biases
This thought-piece was intended to focus on the foundational, and more hard-wired layer of the behavioural biases hierarchy – the cognitive biases. Let us go back to that.
We think of cognitive biases as being classifiable according to the five processes of preferences formulation, self-appraisal, information processing, belief perseverance, and reaction formation.
Preferences Formulation
There are certain flaws in how we formulate and rank our preferences. While rational investors would give similar but opposing weights to gains and losses of the same measure, prospect theory argues that real human investors value gains and losses differently, placing more weight on perceived gains versus perceived losses. Closely related to this is the loss aversion bias – the observation that human beings experience losses asymmetrically more severely than equivalent gains.
Another interesting one under the preferences formulation category of behavioural biases is status quo bias. This is probably one of the most popular ones. It is the tendency of human beings to like things to stay relatively the same even in the face of overwhelming evidence that change is inevitable. We struggle, for instance, with changing our investment managers – don’t we?
There is also the endowment effect. This is often observed through the extent to which investors keep holding on to a stock for too long even against convincing evidence that the stock would not recover any time soon.
We also include regret aversion, hyperbolic discounting, probability weighting, ambiguity aversion, and preference reversal into this category.
Self-Appraisal
While most people think that they are better than the average person even with simple tasks as driving, it is just statistically impossible that there would be more people that are better than the average than those that are worse than it.
Blind spot bias is probably one that should not be difficult to observe. It is the tendency of recognising the impact of biases on the judgment of others, while failing to see the impact of biases on one’s own judgment. More like the famous scripture, “ Why do you look at the speck in your brother’s eye, but fail to notice the beam in your own eye?”
Hindsight bias is another interesting one in this category. With hindsight we are all the wiser – surprised that everyone did not see, like we did, that a past event was very predictable or inevitable.
The hedonics bias is the competency we extrapolate on others that since they are exceptionally talented in one area they should be just as good in others. No wonder why soccer stars have occasionally made it to state houses. In our industry we have had investment managers, because they have been particularly good with managing one asset class, equities for example, suddenly start expanding into managing properties.
Illusion of validity, illusion of control, self-control, self-attribution, and the Ikea effect are also some of the cognitive biases to be aware of, whether you are an investment products provider or an investment products consumer.
Information Processing
We all trust how we process information, right? We rarely pause to wonder if the thought process we are following could in fact be flawed.
House-money effect is a clear example of this. We tend to feel less pain on losing that which we previously gained from the markets compared to losing the original capital we brought in the first place. Truth of the matter is, once the money is in your account, it is yours and losing it should be just as painful whether in your mental accounting it is part of the previous gains or the original capital.
Of course, mental accounting is itself a cognitive bias that causes us to compartmentalise our bank account balances into different buckets according to source or intended purpose.
With the introduction of offshore investments, trustees are best advised to stay alert to home bias and its effects on investment decisions. That there is only so little that has been invested offshore, more than one year after regulation allows it, is a reflection of home bias at play, among other factors of course.
Discounting, risk compensation, framing, anchoring, availability bias, recency, illusion of correlation, narrative fallacy, outcome bias, survivorship bias, information bias, default effect, and salience effect are all the other cognitive biases that fall into this category.
Belief Perseverance
We all have experienced this. Arguing on matters of beliefs is certainly amongst the most tiring and emotionally charged arguments one can have. The beliefs could be about anything, including our beliefs on how investment markets work and how that could then be manipulated to generate positive performance. Arguments on such mostly leave each party even more entrenched into their own beliefs – defeating the whole purpose of having engaged in the argument in the first place.
Confirmation bias is probably one of the most dominant ones of them all in this category. It is the tendency of people to search, interpret, and recall information in a way that aligns with their pre-existing values, opinions, or beliefs. It refers to the ability to recollect information best when it amplifies what we already believe.
Hot-hand fallacy is an “investor-beware” type of bias. It is the belief that a person who has experienced success with a random event has a greater chance of further success in additional attempts. When assessing investment managers, it is important that trustees have the tools to dissect the investment performance and be able to separate skill from luck.
We find the gambler’s fallacy also an interesting one. After getting three heads on tossing a coin you are almost “stone sure” that the next toss is going to be a tail because “it cannot be heads forever”. Not only are you not anywhere near “forever”, the coin does not have a memory of how it landed on the previous tosses – each toss still has a 50:50 chance of landing head or tail.
Conservatism, cognitive dissonance, representativeness, and the law of small numbers are amongst the other biases that are hinged on belief perseverance.
Reaction Formation
Investment management is an ongoing process of acting on, or reacting to, market dynamics. While there is always a sense of being in control when acting on the market dynamics, it is not the same when reacting to the same. With the later, there is always a sense of urgency, uncertainty, and incomplete-information limitations. It is thus critical that market participants are diligent when in a reactionary mode – else their behavioural biases will have the better of them.
Escalation of commitment is quite a fascinating one of the biases found here. It is the tendency to remain committed to our past behaviors, particularly those exhibited publicly, even if they do not have desirable outcomes. Investment managers may allocate even more capital to a stock whose price is endlessly falling with no potential for recovery in sight, because they argued strongly at the outset that the stock resembled a good buying opportunity.
Action bias seems too obvious to mention specifically here, but it is the one that we find most participants grappling with. This is especially so if the action is in reaction to some media hype on a particular investment thesis. Action bias is the failure to overcome the urge to act even when folding one’s arms and doing absolutely nothing is the best option. The massive plummeting of security prices of March 2020 can squarely be attributed to action bias as investors responded to what seemed like the beginning of a bottomless freefall – we now know it was not, but just an illusion.
Disposition effect is the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value. While on face value this seems consistent with the “buy low, sell high” principle, the flaws are in the way it is done.
Reactive devaluation and herding are the two other biases that we classify under the reaction formation category.
Conclusion
Human beings are no “rational beings”. This truth has fundamental implications on how investors, boards of trustees for instance, and investment managers should relate. It should be a common point of understanding that, contrary to standard finance, ingrained in us are behavioural biases that, if unchecked, can be the most impactful single set of performance detractors.
………., and in case you haven’t read it, one of our most read thought pieces, on trustee remuneration, “Trustee Remuneration? What Remuneration?”, is found at our home here, www.rimcasolutions.com/insights
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