Behavioral Finance – A Field of Cognitive Biases

“The radical insight of Behavioural Finance is that people are human” – Werner De Bondt, October 1999

In this article, we will explore the field of Behavioural Finance, which is a small topic in CM2 but resides deep in us. The CM2 material has more detailed content on this topic than CT8 material.  A 5-10 marks question is expected in IFOA  exam. Through this article, I intend to make Behavioural Finance simple to understand and easy to score.

What is it ?
Behavioral Finance is the intersection of Psychology and Finance. It seeks to explain stock market movements by looking into emotions and behavior of investors. It explains investor behavior in situations where their decisions seem inconsistent with the traditional finance theory. The traditional economic theory assumes that all investors are rational and Behavioral Finance questions this assumption and studies the cognitive biases that cause deviation from rationality.

Root of bias:

Daniel Kahneman, a psychologist notable for his work in Judgement and decision making, introduced the concept of System 1 and System 2 to explain the cause of these biases. System 1 and System 2 are simply the two parts of your brain, the intuitive and the rational part respectively, responsible for slow and fast thinking respectively. System 1 generates suggestions, impressions, intentions, and feelings. 

It operates automatically and cannot be turned off at will, for example, you cannot prevent yourself from knowing that 2+2=4. System 2 allocates attention to effortful activities. It is responsible for rational decision making… System 1 is prone to systematic errors in intuition that causes cognitive biases

The biases that are studied in Behavioural Finance are not only faced by people when making investment decisions but also while making routine – life decisions.

Types of Biases:

We will look at a few biases below,

Anchoring:  Answer these questions
Is the height of the tallest redwood more or less than 1100 feet?
What is your best guess about the height of the tallest redwood?

The response to the second question has values close to 1100 feet. The true height might not be close to 1100 ft but the estimates that we provide get influenced by the anchor-value, 1100 ft and we adjust our estimate to it. This is Anchoring and Adjustment. The bigger the difference between the anchor value and pre-anchor estimate, the greater the influence of the anchor value on post-anchor estimate. There is another effect if anchoring that is caused by our preconceived notions on a thing.

Availability bias: Answer this,
Which job do you think is more dangerous, police officer or a logger? The answer that comes to our mind is the police officer’s job but statistically, the job of a logger is more precarious. This happens due to the decision being made by our brain based on the limited data available to it. Judgments are influenced by the ease with which something can be brought to mind.

Framing bias: Answer the following questions sequentially,

How happy are you these days?
Now look the questions this way,
How many dates did you have last month?
How happy are you these days?

While answering the second set of questions, a bias was introduced when you were first asked about the dates, the answer to the next question depended on if you had a good dating period. In the first set of questions, both the answers were independent. The effect was due to the framing heuristic.

Prospect Theory (developed by Daniel Kahneman and Amos Tversky):Consider these questions,

Problem 1: Which do you choose?
Get $900 for sure or 90% chance to get $1000
Problem 2: Which do you choose? Lose $900 for sure or 90% chance to lose $1000

A deviation from economic utility theory was observed when investors wouldn’t choose the option that maximized their expected wealth. It was found that they ride on losses and book their profits when rationally, they must book their loss and ride on profits. It talks about how the decisions are influenced by the gains or losses from a reference point.

Representativeness: Representativeness occurs because it is easier and quicker for our brain to compare a situation to a similar one (System 1) than assess it probabilistically on its own merits (System 2).  This is also related to the law of small numbers, where people assess the probability of something occurring based on its occurrence in a small, statistically-unrepresentative sample due to a desire to make sense of the uncertain situation.

Myopic loss aversion: As the name suggests, investors are averse to short term losses. In an attempt  to have profitable short-term periods, investors take less risk and lose out on profitable returns from investments they would have made had they considered a long time period.

Herd mentality: Herd behavior describes the tendency of people to follow or mimic the actions and decisions taken by others, as a mechanism to deal with uncertain situations. The underlying rationale may be that others must know better (safety in numbers), learning or conformity preferences. Stock bubbles are a result of herd behavior.

Endowment effect: the endowment effect occurs when a person’s preferences depend upon what they already possess. This implies that a person’s preferences depend upon a certain reference point, perhaps determined by the person’s possessions. Ownership itself creates satisfaction. This is similar to Prospect Theory.

Self-serving bias: Occurs when people credit favorable or positive outcomes to their own capabilities or skills while blaming external forces or others for any negative outcomes. This may be done in order to maintain a positive self-image and avoid what psychologists call ‘cognitive-dissonance’, which is the discomfort felt when there is a discrepancy between the perceived self and the actual self – as evidenced by outcomes. It is similar to confirmation bias under overconfidence.

Overconfidence: Overconfidence occurs when people systematically overestimate their own capabilities, judgment and abilities. Moreover, studies show that the discrepancy between accuracy and overconfidence increases (in all but the simplest tasks) as the respondent becomes more knowledgeable! Accuracy increases to a modest degree but confidence increases to a much larger degree.

The biases are driven by intuition and emotions. And Anthony Bolton said, “If you are very emotional you may not make a good investment as you will be influenced by the prevailing investment climate.”

The question that arises is can the biases be overcome?

The answer is biases cannot always be avoided consistently because System 2 may have no clue to the error.

What’s important is that people should be aware of the biases they go through and then accept it. People who are overconfident wouldn’t readily accept that they are overconfident. Acceptance is the first step towards solution.

Some techniques that can be applied while making investment decisions are:

  • Have quantitative approach – Read the financial statements of companies you are investing in.
  • Take care to avoid bubbles
  • If the numbers don’t stack up, try not to make the investment fit – it won’t, because it’s illogical.
  • Taking a disciplined approach to portfolio rebalancing or commitment to regular monthly savings
  • Remember, ‘a watched kettle never boils’, to overcome myopic loss aversion.
  • Go for counter-stereotyping activities and counter stereotypes like male nurses, female scientists, elderly athletes and the like.
  • Identify the anchors influencing your decision and try to avoid following some expert’s comment on a stock to avoid making irrational decision. As Rakesh Jhunjhunwala said, “If you hear me buying a share then either it’s too late or it’s rumour.”

It is important to be aware of the biases and not get swayed away by the market news. As rightly said by Benjamin Graham,

“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” The article has been greatly inspired by Daniel Kahneman’s book, “Thinking Fast and Slow”. You must check it out if this topic interests you.

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