Equity Fund Managers: Behavioural Finance - Essay Example

Do you believe that equity fund managers with a good knowledge of behavioural finance can consistently outperform the market on a risk-adjusted basis? Behavioural finance is emerging phenomenon in most equity markets these days. It basically talks about how investors make decisions and in turn how this affects the stock prices in the market and other broad market movements. This field combines psychology with finance and tries to explain what happens in the markets where humans who are considered rational act in a particular way because of their own limitations and complications. As opposed to traditional finance, whose underlying assumption is that investors are “rational” beings; this rationality tries to point out that as the fund managers receive information they react spontaneously and update their briefs as soon as possible and also explains that given their briefs they make choices that are normatively acceptable1. Whereas, behavioural finance as mentioned is a new phenomenon which points out areas that are more towards reality because it tries to explain investors’ or the fund managers’ decisions by application of models and tools that takes into account the irrationality of the investors; thus here, it tries to talk about what happens when fund managers do not update their briefs as quickly and also do not stay in the acceptable norms. The proponents of behavioural finance argue that use of traditional pricing or valuing techniques such as capital asset pricing models, dividend discount models, relative valuation models etc. does not always explain why the excess returns have been earned at the end of the day by the investors in the light of the efficient markets, thus suggesting that if investors were rational then these techniques would rightly project the prices and no security would have been traded excepting at their fair values. Whereas, behavioural finance attempts to points out the anomalies in the fair values and the decisions that fund managers make in the market. The flawed or the irrational human behaviour is a victim to the phenomena like herd mentality, contagion effect, loss aversion, extrapolation, hindsight bias and illusions of control2. Here emotional factors and intuition to a large extent are the decisive factors in trading. Some of the most likely occurrences that can lead to fund managers deviate from making rational decisions in the market include importance of playing safe compared to earning high risk significant gains and also following the herd versus relying on self. Fund managers when offered a sure shot amount compared to something that is doubtful are more likely to accept the sure amount and forego any larger returns that are risky, similarly, fund managers also show the tendency to recoup any losses than possibility of earning greater gains. This might lead the followers of behavioural finance to protect their turfs and outperform markets. Besides, behavioural finance has also found out that fund managers follow the herd and attribute buying or selling of a particular security to skill rather than to an analysis of the particular stock that might lead to winning. When following the herd then price pressures are more likely to help earn the significant returns. Besides, three phenomena that affect the decision making sub consciously and also leads managers to make decisions include, systematic wrong estimation, aversion of loss, and thinking in new horizons. The over exaggeration or being too optimistic about the market is because of the systematic wrong observation; using such a decision making approach is wrong and not beneficial in the future because, fund managers tend to think that nothing can happen in future that tends to surpass their expectations and thus their biasness leads them to get adamant to their ideas, which can lead them to losses. Also mentioned that irrational investors are averse to loss and thus for the fund managers it becomes hard to accept the loss and studies have shown that in circumstances, fund managers are always eager to sell the winners but keep on hooked to their positions even when they see that they are facing the losses. Combined with being overly optimistic this leads them to get biased with their own intuitive valuation rather than fair price. Another, narrow minded attitude of behavioural fund managers is that they are myopic and therefore, they pay less heed to the long term implications of earning profits; and more likely to sell off their earnings to avoid losses or earn minimum gains where on the other hand they see long term providing them with more high returns. Another area, which the irrational fund managers tend to ignore, is the fact that capital markets are also subjected to fashions and fads3. But, here behavioural finance can be used to identify and recognize trends by aligning quantitative analysis with the qualitative variables. Behavioural finance can be used best in the asset selection for the portfolio by the fund managers, based on the experience and building of intuition this leads to development of performance in asset allocation. But, behavioural finance does play by the rules also; at first they consider the relative change in the stock market trends in quantifiable terms, this also provides insight into the market players’ current level of interest and participation. In the next stage, for each sector future development and the relationship between prices are analyzed. And then future decisions are made which are not at all random. Alone, we cannot base any decision on the basis of either traditional valuations or rely solely on the behavioural finance valuations; as it is said: “While markets get blown around by sentiment and noise, in the long run, it is valuations that determine returns,” says Montier.4 Some of the mistakes that arise from use of solely behavioural finance is because of the mental models that are used to solve complex problems; this results in problems like anchoring, framing, representativeness etc. Thus, fund managers should not be moved or base their decisions randomly, instead accompany and support their decisions on value based judgments also. To make use of behavioural finance effectively, fund managers should be humble in their approach to investment, they should avoid leverage, diversify and minimize trading thus avoiding myopic view; they should be patient and not be overly optimistic, the focus should not be on a single stock as believed that a watched stock never rises. Rather than staying biased with their own ideas, fund managers should actively seek contrary opinions and do not always be fooled by the randomness; one point that was earlier pointed out was that all security prices ultimately turn back to their mean, hence fund managers should also benefit b earning profits from regression to their mean.5 References Barberis, N, Thaler R., Handbook of the Economics of Finance, Edited by G.M. Constantinides, M. Harris and R. Stulz Khatib, F., Singai. V. Point-Counterpoint, CFA Magazine Sep/Oct 2003 Behavioral Finance Innovation as a part of wealth enhancing culture LGT – The Bank of the Princely House of Liechtenstein Wilson, S. Does our psychology move markets? Available from http://www.moneyweek.com/file/6352/does-our-psychology-move-markets.html [Accessed October 11, 2007] Tilson, W. Applying Behavioral Finance to Value Investing Read More