Briefing notes on behavioural finance

Behavioural finance seeks to combine cognitive psychological theory with conventional economics and finance to explain why people make irrational decisions. To process the vast amounts of incoming information human brains receive, they use a set of compression schemes to abstract critical elements. Essentially, information is simplified, but the process is subject to biasing effects and result in contradictory beliefs.

Psychologists have revealed dozens of cognitive biases and some of those most relevant to the investment world are presented here:

Social biases

These relate to the desire to be part of a social group and seek out harmony over conflict.  

Herd behaviour – This describes a propensity for people to mimic the actions of a larger group when individually they would not necessarily make the same choice. It has manifested itself in the creation of investment bubbles.

Groupthink – This arises from a greater need among a group to get along and agree with one another rather than seek out and critically assess alternative views.

Sunflower management – This describes a tendency for employees to align their views with the views of their leaders whether expressed or assumed.

Pattern recognition biases

These describe the tendency of people to seek out patterns where there are none.  

Confirmation bias – This is the tendency to give a higher weighting to information that supports a favoured belief and not pay enough attention to evidence that challenges it. As a result, investment decisions are based on one-sided information because the investor failed to seek out impartial evidence. 

Saliency bias – This is an overreaction to new information. The efficient market hypothesis describes a market where new information is reflected instantly in a share price. In reality, investors are more likley to overreact to new information, which creates a surge in the share price that erodes over time.

Gamblers fallacy – This describes the belief than a certain random event is less likely to happen following an event or a series of events. Some investors hold onto a share for too long following a series of falls because they think further declines are unlikely.

Action orientated biases

These are present when people take action without proper consideration and are worryingly familiar to anyone whose has suffered from a financial crisis.  

Overconfidence – Overconfidence can seriously damage your wealth. It can lead us to overestimate our ability to affect future outcomes, take credit for past outcomes and neglect the role of chance. The widespread adoption of mathematical models that measure risk created an impression that markets could be tamed and led to overconfidence that was shattered by the financial crisis.

Excessive optimism – This is the tendency for people to be overoptimistic about the likelihood of positive events and underestimate the likelihood of negative ones.

Stability biases

These occur when uncertainly creates inertia.

Anchoring – This is present when investors root themselves to an initial value based on irrelevant facts and figures. A change in events can cause a stock to halve in value. If an investor anchors to the previous high in the belief that the stock is undervalued using information that is no longer relevant, he has fallen prey to this bias.

Failure of invariance – Experiments that revealed this bias identified a striking asymmetry: risk aversion for positive outcomes, but risk seeking for negative ones. It explains a tendency for investors to hold onto losing stocks for too long and sell winning stocks too soon.