Behavioural Finance in the Field of Finance and Investment

Introduction

The intention of this essay is to analyse the development of ‘Behavioural Finance’ within the field of finance and investment. It will highlight some of the literature that has come about as a result of research in the field, some of the implications it has had on historical theories and some of the implications it has had within the world of investment.

The Birth of Behavioural Finance

Behavioural Finance is considered by many to be a new field within finance, but it does have its origins in the early 20th century. One of the initial publications to highlight the importance of investor psychology was authored in 1912 by George Selden, the intention of this book was to discuss the “belief that the movements of prices on the exchanges are dependant to a very large degree on the mental attitude of the investing and trading public”(Selden, 1912, pp. Preface), this was a pioneering thought and began the start of linking psychological aspects within the world of finance.

Throughout the 20th century, many developments were made in relation to combining psychological aspects to the world of finance. Since George Selden, many have built upon this idea and “in 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance.”(Sewell, 2010, p.1). This was of importance as considering the dynamic nature of finance, a decision one makes can often be offset by the introduction of new and inconsistent information, this may often lead practitioners to make irrational decisions which in turn affects markets, pricings and causes inefficiencies. After this, John Pratt “considers utility functions [and] risk aversion”(Sewell, 2010, p.1), which considers how practitioners evaluate a monetary amount gained or lost and also how they feel about incurring various levels of risk and how this affects behaviour and decision making. From this point the research and developments entered rapid expansion as more researchers and prominent people within the fields began to take interest in this idea that psychology may play an important role within markets and practitioner behaviour..

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In 1973, two psychologists, Amos Tversky and Daniel Kahneman put forth an article and within this paper they “explore[d] a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e., by the ease with which relevant instances come to mind.”(Tversky and Kahneman, 1973, p.207).

A heuristic is something that financial “practitioners use [as a] rule of thumb…to process data… they are generally imperfect. Therefore, practitioners hold biased beliefs that predispose them to commit errors.”(Shefrin, 1999, p. 4). This along with the earlier articles and research began to explore in more depth the affects of individuals’ cognitive errors and misjudgements which we now know can lead to market inefficiencies.

Then, in 1974, Tverky and Kahneman produced another article with the intention of further developing the field and gaining a more in depth determination of the heuristic identified in their previous paper, within this article they had identified and described three heuristics which can be seen to be in use when making decisions under uncertainty. These three heuristics are as follows; “representativeness, which is usually employed when people are asked to judge the probability that an object or event A belongs to class or process B,”(Tversky and Kahneman, 1974, p.1124) in simple terms this is when someone tries to predict the probability of an unknown event by comparing it to a known event and assuming the probabilities will be similar. This can and usually does lead to errors as practitioners may over or underestimate the probability, and also may misjudge the comparative example which in turn will lead to errors.

The second heuristic is that of “availability of instances or scenarios, which is often employed when are asked to assess the frequency of a class or the plausibility of a particular development,”(Tversky and Kahneman, 1974, p.1131) in simple terms they have described a way in which individuals are more inclined to assess the frequency of an event by the ease in which instances of the events can be brought to mind.

The third heuristic is that of “adjustment from an anchor, which is usually employed in numerical predication when a relevant value is available”(Tversky and Kahneman, 1974, p.1131) in simpler terms they have described how an individual will use an initial piece of information and then any other piece of information gained thereafter will encounter a bias based on the initial information. This leads the practitioner to hold on to their initial beliefs in regard to the scenario and leads to an inaccurate reading of the situation resulting in errors.

These are heuristics, which are mental-shortcuts which, through a lack of adequate mental analysis and evaluation, lead to an inaccurate reading of the situation, leading to a misjudgement. These heuristics are important as they began to form reasons why financial practitioners’ are prone to make mistakes, which in-turn lead to market inefficiencies and in the area of investment cause stock-prices to deviate from their fundamental value.

From this point, Tversky and Kahneman went on to produce another article in 1979 They discovered that people tended to value losses greater than equivalent gains; “An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights.”(Tversky and Kahneman, 1979, p. 263). This was named Prospect Theory. This was an important development as it showed further irrational behavioural of practitioners and put greater emphasis on the study of how human errors do affect the financial markets, something that was held in contrast to popular belief at the time, it also contributed further to the study of how practitioners deal with the evaluation of money.

Then, in 1985, Werner De Bondt and Richard Thaler published an article that discovered that “most people tend to ‘overreact’ to unexpected and dramatic news events.. The empirical evidence… is consistent with the overreaction hypothesis… market inefficiencies are discovered.”(De Bondt and Thaler, 1986, p.793). This discovery, aided by the previous advancements of the better part of a century’s worth of research effectively formed the start of what has become known as behavioural finance and was of great importance and the field now had empirical evidence which backed up theory to suggest that psychological errors contributed to market inefficiencies thereby putting into question historical theories which had once been considered valid.

To summarise, over the course of the 20th century there has been significant research within the field of psychology and then a merging of psychological research with the field of finance. Many consider Amos Tversky and Daniel Kahneman to be the pioneers with the vast amount of research they conducted in the field, which lead to Werner De Bondt and Richard Thaler producing empirical evidence, with the use of psychologically based background, in their paper; “Does the Stock Market Overreact?”which proved that at times there exists inefficiencies within the markets.

How it has Affected Historical Theories

The birth of Behavioural Finance has had many implications within the fields of finance and investment. One of its greatest and most important impacts is calling into question the rationality of financial practitioners, this notion that practitioners are rational provided an assumption which formed the foundation on which some of the most influential economic and financial hypothesis were created.

To analyse the full impact of behavioural finance as a topic is something that cannot be achieved within this essay, instead it will discuss its effect on Efficient Market Hypothesis (EMH), a theory put forth by Eugene Fama in 1970 titled “Efficient Capital Markets: A Review of Theory and Empirical Work,”(Fama, 1970) . Within the document Fama describes an efficient market as “a market in which prices always ‘fully reflect’ available information,”(Fama, 1970, p. 383) in order for markets to fully reflect available information an assumption is made that the markets and the investors within them are rational, this is one of the assumptions that provides a foundation for Efficient Market Hypothesis;

This notion of rational markets and investors has been seriously questioned by the development of ‘Behavioural Finance’ and due to the research that has been conducted and empirical evidence which proves that at times the markets both over and under react to information which results in inefficiencies; it can be stated that the Efficient Market Hypothesis isn’t entirely correct. This is important as since the theories inception; financial practitioners accepted it as valid and began to develop ideas, models and other theories with EMH as a foundation. Other theories such as Capital Asset Pricing Model have been put into question as they were developed and “buil[t] on the assumptions of EMH.”(Bell, 2010).

The development of ‘Behavioural Finance’ and the findings from various researches which put into question market efficiencies, it can now be stated that long held beliefs and theories about the way markets and financial practitioners operate can be considered false. It has also brought about an idea named ‘Adaptive Market Hypothesis (AMH)’ which was put forth in 2004 by Andrew Lo, he argues that “the emerging discipline of behavioural economics and finance has challenged [EMH], arguing that markets are not rational… [he] propose[s] a new framework that reconciles market efficiency with behavioural alternatives.”(Lo, 2004). This new hypothesis seems to make more sense and is in conjunction with behavioural finance issues and while we wait for it to be solidified by long-term empirical evidence, it seems that the future is more AMH than EMH.

Its implications for Investment

Since the development of ‘Behavioural Finance’ and the psychological aspects that are at play within the world of finance and within the investors psyche have been seen to “lead to unhelpful or even hurtful decisions. As a fundamental part of human nature, these biases affect all types of investors,”(Byrne and Utkus, 2013, p.4) and often lead to misjudgements and errors, the implications for this are that each and every investor will make use of these heuristics and inevitability will make mistakes. The world of investment has now recognised that this area of study is of great importance and can help explain not only investor behaviour, but also the behaviour of markets. One of the intentions of ‘Behavioural Finance’ is to identify these errors and their causes so that investors are in a position to work around them or profit from other investors’ mistakes.

There are now many heuristics and biases which have been discovered and have an impact on financial practitioners decision making ability and in turn have implications for markets, some of these are as follows; Availability Bias, Representativeness, Gamblers Fallacy, Frame Dependence, Mental Accounting, Loss Aversion and Overconfidence to name just small amount. One of these biases, ‘Overconfidence’, “has found that humans tend to have unwarranted confidence in their decision making. In essence, this means having an inflated view of one’s own ability.”(Byrne and Utkus, 2013, p.4). In terms of investment this can lead some investors to have placed an overestimation on their own investment choices and ability and as such, at times, disregard the overall external factors which have an impact on the market. Another affect that overconfidence may have on certain investors is in relation to trading, for example, too much confidence is placed within their own ability to trade. “Professors Brad Barber and Terry Odean studied US investors with retailed brokerage accounts and found that more active traders earned the lowest returns.”(Byrne and Utkus, 2013, p.6).

Another bias is that of the ‘loss aversion’ where “behavioural finance suggests investors are more sensitive to loss than to risk and return,”(Byrne and Utkus, 2013, p.8) where traditional finance theory tended to focus solely on the relationship between risk and return. Two professors, Hersh Shefrin and Meir Statman, developed theories put forth by Tversky and Kahneman in a paper titled “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”where they found evidence to suggest that investors “sell winners too early and hold losers too long.”(Shefrin and Statman, 1985, p.777). This can negatively affect investor returns and depicts some form of short-termism within investors’ psychology down to the bias of loss aversion.

Conclusion

To conclude, ‘Behavioural Finance’ is a field that has had profound effects on the world of finance and investment, so much so it has put into question previous theories that were once considered valid and used as a foundation for most economic and financial hypotheses such as EMH and CAPM. As the field has developed practitioners have taken more notice of their own and others’ irrational behaviour, which is important considering prior to the introduction of psychological issues most were of the belief that themselves and others were rational. This can now be considered to be false, and as the dynamic nature of the financial work-environment induces mental and behavioural short-comings it is likely that the field will see further developments.

Bibliography

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