Where finance and psychology meet

Article provided by Capricorn Investment Partners Limited, Australia.

Behavioural finance is a relatively new field of expertise which is starting to impact on the broader financial industry. Don’t be put off by visions of tweed-clad Oxford dons discussing Pavlov’s dog and what it means for the stock market, there are a number of useful messages and findings for which behavioural finance can claim the credit.

Behavioural finance (and its older established cousin, behavioural economics), attempts to understand why investors and other individuals make decisions and the impact that these decisions can have on markets, prices and investment returns. It may come as some surprise, but as clever as we think we are, people are governed by a number of basic impulses.

Those impulses influence our decisions and our reactions to the consequences of those decisions. A predisposition toward emotions of either hope or fear has a significant effect on the decision investors make.

Emotional decisions can be irrational. For example, it has been proven that investors feel a loss twice as much (in a psychological sense) as a gain¹. As far as the psychologists are concerned, such a response is irrational – isn’t a capital gain of $100 the same as a capital loss of $100? Not if you are like 99 per cent of society. Wanting to avoid a loss more than making an equivalent gain is known as loss aversion.

Loss aversion may sound obvious, but it is quite significant. Decisions like these, made by hundreds of people, introduce inefficiencies into the stock market. Astute investors may be able to use this to their advantage.

Loss aversion also leads investors into ‘get-evenitis’, where investors who hang on to shares that have fallen in value, in the sometimes vain hope that one day the share price will get back to the price at which they first bought it, allowing them to sell without incurring a loss.

We are not advocating that every share which falls in price should be sold off immediately, just that we need to be aware of falling into the trap of ‘get-evenitis’. It is often said, very truthfully, that the hardest decision is not what shares to buy, but what to sell.

Another favourite of the behavioural finance crowd is gambler’s fallacy, a neat name for the erroneous belief that the odds of a fixed odds event occurring increase or decrease depending on recent occurrences. For example, if we toss a coin 30 times and it lands on heads each time, you would be forgiven for thinking that there was a very high chance of it finally landing on tails on the next toss. Of course, the odds are still no more than 50 per cent that it will be tails on the next toss.

Gambler’s fallacy too has a role in the stock market, as people see (or think they see) patterns in price movements based on previous movements, and attempt to try and take advantage of the next perceived movement. Again this introduces inefficiencies into the market, which allows other investors to earn an excess return for taking an opposite position.

We’ve included this article to highlight CIPL’s role in helping to navigate through difficult economic times, and to take advantage of better conditions. The media would have had clients sell everything last year. With markets now recovering it would have been the worst choice of all.

¹ Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. Quarterly Journal of Economics 106, 1039-1061.