Behavioural Finance - Essay Example

BEHAVIOURAL FINANCE Behavioural finance, fundamentally speaking, is the humanistic approach to financial decision making, where quite often the generally accepted rules of accounting, cash management, p/e ratios and other criteria used to make wise decisions often do not apply, or their application is jaundiced by other psychological criteria. The motto ‘buy low – sell high’ is a standard in the industry but the opposite often becomes the rallying cry as investors panic in a crisis and sell low while seeing stocks on the upswing, buy high. This is, of course, a very broad introduction to a much more complex subject, but in order to understand behavioural finance one has to understand human psychological responses and emotions that are involved in these decisions. However, while these retreats from rationality may seem chaotic and random to the savvy investor, the application of psychology to finance may help to not only explain, but also predict this seemingly haphazard behaviour. Therefore, stated a bit more succinctly, behavioural finance examines how the human animal reacts in a financial system theoretically devoid of any emotions. This has been referred to in the past as ‘open-minded finance’ (Thaler 1993) which is a generous expression implying that many investors often behave in a quite contradictory manner to the advice given them by their financial advisors. ‘Proponents of behavioural finance contend that people may not always be “rational,” but they are always “human.” Thus, behavioural finance exposes the irrationality of investors in general and shows human fallibility in competitive markets.’ (Baker and Nofsinger 2002: 99) To many the idea of market efficiency itself goes out the window when the concept of human behavioural finance comes in. The argument is stated that the market is in reality not efficient to begin with since the majority of personal investors operate in a mostly unpredictable fashion which by most standards is considered irrational. This conundrum gave rise to the research that became behavioural finance, which emphasises the impact of investor behaviour on the market and the seeming problems it can create towards market efficiency, or lack thereof. (Gaffikin 2007) The experience of the stock market bubble has given impetus to the theory of behavioural finance, which places greater emphasis on human motivation and market inefficiency. Yet investment bankers and business people appear to put ever greater faith in the verdict of the stock market when making judgements that can have a big impact on output and employment. (Plender 2003:129) One of the major contributors over the past several decades to the amount of influence individual investor behaviour has on the marketplace is the plethora of information and investment resources that are now available to the individual through access to the internet as well as the constant barrage of financial pundits in the various media channels. Stocks can also be traded instantaneously (via e-trade and the like) by individuals who may have little or no real insight into what they are playing at and may send a knee-jerk reaction that if analysed more circumspectly they may have avoided. The rise of the Internet dramatically changed the way people make investment decisions (Barber & Odean, 2000b)…For example, the Internet fosters active involvement by providing the medium for investment chat rooms, message boards, and newsgroups. Millions of people started investing online over the past several years. In the late 1990s and early 2000, a tremendous surge occurred in investor trading… If this online investing behaviour magnifies the investor's biases, then trading patterns in those accounts that are consistent with the behavioural predictions … should surface. For example, online traders should exhibit signs of overconfidence, such as more frequent trading. (Baker and Nofsinger 2002:102) This hyper learning-performance curve many researchers believe is a considerable causational factor in behavioural finance and market instability. The counterbalance question is, would this partially learned irrational behaviour remain consistent over time or if the introduction of rational learning and sound financial principles of investment would offset the trend. (Bullard 2006) Many researches are seeking to prove just this, that increased financial literacy and financial knowledge can lead to increasing changes in irrational financial behaviour. Johnson and Sherraden (2008) support this concept but believe there is more to it than the simple absorption of facts and figures. They, as many would hope, feel that fuller participation in an individual’s personal financial investments would increase their ability to lead more fuller and complete lives. This requires knowledge and competencies, ability to act on that knowledge, and opportunity to act. This involves linking individual functioning to institutions. It also involves use of pedagogical methods that enable people to practice and gain competency in this functioning. We refer to this as ‘financial capability.’ (Johnson and Sherraden 2007: 121) According to these researchers, financial capability integrates the skills, behaviour, and knowledge of five areas: making ends meet, keeping track, planning ahead, choosing products, and staying informed. (Johnson and Sherraden 2007: 122) While these are certainly fruitful areas of study, humans also possess another individual trait, personalities. Knorr-Cetina and Preda (2005) have designated two personality types and given them market monikers, ‘equity investors’ and 'fixed-income investors', comparing them in the risk pool as polar-opposite personalities. ‘Compared to other respondents, “equity investors” believe more that they are leaders, and that they make decisions quickly. They admire entrepreneurship.’ (Knorr-Cetina and Preda 2005:181) Equity investors’ main characteristic is their love of risk and their belief that financial investment is fun and a challenge. As stated, they are great believers in entrepreneurship and believe they are closet entrepreneurs creating their own personal company out of their investments. ‘They believe that successful investing requires effort. In their view, stocks are the best long run investments, small companies earn higher stock returns than large companies, and modern technology has made investing easier.’ (Knorr-Cetina and Preda 2005:183) This is in sharp contrast to the fixed-income investors who are more concerned about the tenuous nature of the future than are equity investors and have a greater fear of failure than their counterparts. They believe many of the tenants of the greater culture that state that, 'regulation benefits society, that working for government is a noble task, that social security will provide retirement income.’ (Knorr-Cetina and Preda 2005:183) Fixed-income investors also lack the self-confidence to make financial decisions, and worry a great deal about stock market volatility and they often prefer the more stable and lower risk (and also lower income) investments such as CD’s, savings accounts as well as Gold and other such commodities. Fixed-income investors also bring an ethical dimension into investing that, while being highly moral, can be counterproductive to wise decision making: Another part of Behavioural Finance is Prospect theory: Prospect theory provides a descriptive framework for the way people make choices in the face of risk and uncertainty. Decision-making involves two processes: editing and evaluation. The editing phase organizes, simplifies, and reformulates the prospects. The evaluation phase places a value on each prospect in order to identify the one with the highest value. However, the value function used has some asymmetries. The value of a $1 changes depending on whether it is a gain, loss, or follows other gains or losses. (Baker and Nofsinger 2002) While this is certainly a human component of financial evaluation, if feed with proper experience and educational knowledge it may become an instinct that could be positive and proactive and become an asset when investing. However, depending on experience, negative losses may predispose the personal investor to choose less risky investments or become one of the ‘money under the mattress’ types. However, cumulatively, whatever experience and knowledge the individual investor receives it all becomes part of their profile and part of the possible predictability of this area of finance: Behavioural finance relaxes the usual assumptions of traditional finance by incorporating observable, systematic, and very human departures from rationality into models of financial markets and behaviour. By combining psychology and finance, researchers hope to better explain certain features of securities markets and investor behavior that appear irrational. (Baker and Nofsinger 2002) While still highly descriptive and influenced by personal feelings and attitudes, research and further study in the area of behavioural finance is certainly warranted given the far reaching effects that the many individual investors have on the overall market. Take for instance the following data gather by Baker and Nofsinger: Consistent with the behavioural prediction, the research shows that individual investors are more likely to sell a stock if it experiences an increase in price than a decrease in price. They find that if a stock outperforms the market by 10%, the investor's likelihood of selling the stock increases by 26%. On the other hand, an underperformance of 10% decreases the likelihood of selling by 14%. Investors do not like to sell losers, only winners. (Baker and Nofsinger 2002) Furthermore, over the past several years a certain amount of distrust in large publicly traded corporations, such as Enron and others, have shattered the notion of ‘too big to fail’ and left a psychological impediment in the minds of many investors. In hindsight many safeguards should have been in place that were not and the financial markets and overseers are rapidly attempting to fix this. Plender believes that there should be a ‘…behavioural audit trail as well as a financial one,’ (2003: 256) and that managers and directors of such corporations should be responsible for. This brings us to the concept of the triple bottom line of people, profit and planet that many corporations now aspire to. However, Plender is quick to point out that altruistic attitudes have to be gauged carefully in a profit oriented environment: By the same token investors will insist on paying less for new issues of securities because they have to be compensated for the risk of being exploited by insiders. And in a low-trust system, expensive litigation becomes a substitute for behavioural constraint. No system can rely on ethical self-restraint alone. It cannot be ignored that self-interest is a vital motivating force for wealth creation. (Plender 2003:240) So Behavioural finance, and the world of the financial markets, must take into account these various psychological factors of individual investors in order to assist them more productively and positively. While the best strategy put forth by a well-credentialed financial advisor may be sound and have a history of success behind it, the personal investor brings with him or her the psychological baggage of their experience and will examine the information presented through that set of their own rules and filters. References Baker, H. Kent, and John R. Nofsinger. 2002. ‘Psychological Biases of Investors.’ Financial Services Review 11:97-111 Bullard, James B. 2006. ‘The Learnability Criterion and Monetary Policy.’ Review - Federal Reserve Bank of St. Louis 88:203-212. Gaffikin, Michael. 2007. ‘Accounting Research and Theory: the Age of Neo-empiricism.’ Australasian Accounting Business & Finance Journal 1:1-12 Johnson, Elizabeth, and Margaret S. Sherraden. 2007. ‘From Financial Literacy to Financial Capability among Youth.’ Journal of Sociology & Social Welfare 34:119-127. Knorr-Cetina, Karin and Alex Preda, eds. 2005. The Sociology of Financial Markets. Oxford, England: Oxford University Press Plender, John. 2003. Going off the Rails: Global Capital and the Crisis of Legitimacy. Chichester, England: John Wiley & Sons. Thaler, Richard H. 1993. Advances in behavioral finance, Volume 1. New York, New York: Russell Sage Foundation Read More