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Understanding how the mind can help or hinder investment success
What behaviours prevent us from making the right investment choices? And how can we improve our investment decision making? The study of behavioural finance could lead us to better understand the financial decisions we make.
Behavioural finance is a branch of economics that tries to understand the psychological and behavioural factors which, alongside conventional economic theory, explain why we, as investors, act the way we do.
Twenty years ago, behavioural finance was mostly a scattered collection of research by those who dared to question the classical views of finance. In 2002 however, Daniel Kahneman put behavioural finance front and centre by winning the Nobel Prize in Economics for his work in applying psychological insights to economic theory. The major downturn experienced during the financial crisis of 2007-2008 also heightened interest in behavioural finance. Since then, it has catapulted to become a source of rationale for investors’ decisions.
So, how does behavioural finance contribute to our knowledge of finance? At its core, it provides a framework that not only explains investor behaviours, but also educates investors to help them make more informed decisions.
Understanding behavioural finance
According to conventional investment theories, the price of an asset – such as a share or a bond – is based on rational foundations. These include the financial health and performance of a company or an economy. Classical views of finance assume that people can separate their emotions from their decision making. It holds that given the same level of information investors will make the same choices in a way that aims to maximise their returns and minimise their risks.
However, in practice we often see that this is not the case, and investors can make unexpected, even seemingly irrational decisions. Most people know emotions affect decisions - people in the industry commonly talk about the role greed and fear play in driving stock markets for instance.
Behavioural finance theorists point to investment ‘bubbles’ as primary evidence that market prices can be affected by the irrational behaviour of investors. They cite the Dutch tulip bulb mania of the 1630s, the South Sea Bubble of the 1710s, the junk bond crash of the 1980s and the ‘dot.com’ Internet stock bubble of the 1990s as examples of how investors can get caught up in the enthusiasm for something new and exciting. More recently the value of one Bitcoin rose to nearly US$20,000 in late 2017 but had fallen to around US$3,000 less than a year later.
Behavioural finance theorists propose psychology-based ideas to explain these stock market anomalies. One example that behavioural finance theorists use to illustrate how the actions of investors appear to go against perceived wisdom is the ‘January effect’.
The ‘January effect’
Conventional thinking predicts that investment returns and stock prices follow a ‘random walk’ with no predictable pattern – meaning, that they’re determined by today’s news rather than yesterday’s trends. This is known as the ‘efficient markets hypothesis’ (EMH), which states that asset prices fully reflect all available information – and any changes in price reflect the effects of all relevant information as it is released.
A direct implication of EMH is that it is impossible to achieve consistently better returns than an index (colloquially referred to as ‘beating the market’) because all information that could predict performance is already built into the stock prices - prices should only move in a re-action to new information. That is, information that is available to everyone at the same time. Indeed, the ASX, among other securities exchanges, enact regulations to control how a company releases information that could influence its share price. This aims to ensure a level playing field for all investors.
And yet it was observed that in the US between 1904 and 1974, smaller companies returned 3.5% in January and roughly 0.5% in every other month. Further, from 1928 through to 2019, the S&P 500 rose 62% of the time in January (56 times out of 91).1
In behavioural finance, this ‘January effect’ is explained by investors’ seasonal increase in buying stocks. The US tax year follows the calendar year, and the January rise in share prices is down to investors taking advantage of bargains after retail investors realise losses to offset capital gains made elsewhere. The January Effect is a hypothesis, and suggests that the markets are inefficient, as efficient markets would naturally make this effect non-existent.
This is just one observation that behavioural finance theorists use to explain market inefficiencies, highlighting the point that it’s because people are not mathematical equations, and that individuals are influenced by their personal biases. Other commonly used examples include the ‘winner’s curse’, which considers the tendency of the winning bid in an auction to exceed the fair value of the item purchased, and the ‘equity premium puzzle’ that looks to explain the difference between equity and bond returns. And of course, active investors – those who try to perform better than the benchmark – still demonstrate marked variations in performance throughout the year.
Why behavioural finance?
We are all human, which means that our behaviour is influenced by our psychology. Some decisions are simple, day-to-day choices, such as what brand of laundry detergent we buy. But others significantly impact our financial well-being, such as whether we buy a particular stock, or how we allocate our money among various investments. Behavioural finance suggests that emotion and deeply ingrained biases influence our decisions more than we consciously recognise, and this makes it hard for us to act truly rationally. And, markets to be truly efficient.
Of course, behavioural finance is not without its critics. For instance, Eugene Fama – the founder of EMH – suggests that even though there are some anomalies for which modern financial theory cannot account for, EMH remains the best model for explaining and predicting economies. The biggest critique of behavioural finance however, is that it is more of a philosophy than an actual science, since there are few, if any, controlled experiments to verify cause to effect.
There are supporters on both sides of the debate. However, more investors are increasingly discussing and using the insights of behavioural finance to improve the ways in which they use EMH to make investment decisions. Behavioural finance should not replace modern finance, but it is an important complement. We often make decisions that are psychologically self-serving, or that take away anxiety, but are not necessarily self-serving from a financial perspective. The tenets of behavioural finance can help us all understand our motivations and weaknesses a little better. This can perhaps help us make better – or at least more rational – investment decisions.
[1] Rozeff and Kinney, Capital Market Seasonality: The Case of Stock Returns, 1976. Stephen J Ciccone, ‘January’s Stock Temptation’, The Journal of Behavioural Finance, 2011.
Important information and disclaimer
This article has been prepared by Godfrey Pembroke Limited ABN 23 002 336 254 AFSL 230690. Any advice provided is of a general nature only. It does not take into account your objectives, financial situation or needs. Please seek personal advice before making a decision about a financial product. Information in this article is current as at 4/02/2020. While care has been taken in the preparation of this article, no liability is accepted by Godfrey Pembroke Limited or its related entities, agents or employees for any loss arising from reliance on this article. Any opinions expressed constitute our views at the time of issue and are subject to change. Any tax information provided in this article is intended as a guide only. It is not intended to be a substitute for specialised tax advice. We recommend that you consult with a registered tax agent.