Behavioral Finance: Understanding Investor Behavior
Abstract
This abstract explores Availability Bias and Recency Bias, common cognitive pitfalls for investors. Overestimating memorable events and assigning too much weight to recent occurrences can lead to suboptimal outcomes. To counter these biases, investors should maintain a long-term perspective, use statistical data, and leverage technical indicators. The narrative emphasizes the importance of breaking detrimental habits, including underperformance and premature selling, by prioritizing diversified portfolios, adhering to long-term plans, and seeking information from diverse sources. Seasoned investors stress the significance of learning from past mistakes, especially for those with less experience, highlighting continuous self-reflection and error-focused learning as key contributors to sustained success in financial markets.
Time to read: from 7 minutes.
Level: Fundamental.
Category: Information.
Behavioral Finance, or Finanzas Conductuales in Spanish, represents a field within finance that examines the behavior of investors and how they make financial decisions. In doing so, it employs models to analyze biases that investors exhibit when making financial decisions. These biases lead to repeated mistakes. One notable advancement in behavioral finance theory is its ability to help investors recognize both their own errors and the mistakes of others. These "anomalies" have been documented in various publications and should not have occurred if markets behaved according to the principles of efficient market theory.
During the early 1960s, psychologists Amos Tversky and Daniel Kahneman, through a series of controversial experiments, determined that people's decisions and actions did not appear entirely rational. These authors described and classified the ways in which individuals simplify and resolve financial decision problems, often relying on heuristics and instinct rather than rational analysis.
Market Characteristics and Investor Anxiety
Stock markets possess distinct characteristics that induce significant anxiety among most investors, especially during capital losses. Psychologists studying anxiety and fear have identified four characteristics that make a situation seem much riskier than it actually is: 1) significant consequences; 2) beyond personal control or influence; 3) unfamiliarity; and 4) sudden occurrence. All these factors affect individual investors, thereby influencing the investment decisions they make, often with negative consequences.
Distinguishing between speculation and investment is crucial. Benjamin Graham's definition from 1949 is insightful: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." Long-term investing transforms many risk-perceived factors into manageable ones, providing they are appropriately managed.
Defining the concept of risk in finance presents a challenge, with investors often defining risk subjectively. Whether it is the possibility of losing money in unfamiliar or unknown financial instruments, investing in sectors or instruments where losses have occurred before, or investing outside traditional parameters, the subjective nature of risk complicates its definition.
If risk is defined as the "probability of losing money," it decreases as the investment horizon increases. This is because, in the long term, each asset class should offer a return similar to historical performance, while in the short term, riskier assets may yield negative surprises. On the other hand, if risk is defined as "the amount of money the investor can lose," risk increases with a longer investment horizon, as losses of a certain percentage of the investment portfolio's value are larger in magnitude as the portfolio hypothetically grows over the years.
In the context of investment, risk and uncertainty are two different concepts influencing investors' decision-making processes. Risk refers to the variability of potential investment outcomes and can be measured and quantified using statistical tools like standard deviation or beta. Uncertainty, on the other hand, pertains to the lack of information or knowledge about an investment, where certainty about the number of possible outcomes is lost. Uncertainty arises from unpredictable or unknown situations such as political events, natural disasters, or technological innovations. Investors face both risk and uncertainty when investing in any asset, but they employ different methods to deal with them. Risk can be reduced by diversifying the portfolio, hedging exposure, or adjusting expected returns. Uncertainty can be mitigated by gathering more information, conducting research, or waiting for more clarity.
Traditional finance assumes that the majority of investors have a risk aversion, i.e., they are willing to take on greater risks in their investments only if there is hope for higher returns. This basic principle tends to hold true since, when analyzing very long time periods, stocks generally offer higher returns than bonds, a less risky instrument according to basic risk measures.
However, the average investor possesses minimally diversified investment portfolios, inconsistent with the risk aversion assumption made by traditional finance. This phenomenon can be explained by the premises of behavioral finance. According to these premises, investors prefer to structure their investment portfolios in layers, with each layer having an independent risk level or objective. To illustrate, envision a pyramid constructed in layers, with each layer incorporating financial instruments associated with an investor's goal. The riskiest, last layer would be represented by equity instruments.
Common Pitfalls of Individual Investors
Cognitive biases are distortions or errors in information processing affecting our judgment and financial decisions. Some common biases affecting individual investors and strategies to overcome them include:
Confirmation Bias: The tendency to seek information confirming existing beliefs and ignore or discard contradicting information. To overcome this bias, investors should be aware of their opinions, seek objective and diverse information, be willing to change opinions based on evidence, and admit mistakes.
Overconfidence Bias: The inclination to overestimate one's abilities and judgment accuracy, leading to assuming more risks than justified. Overcoming this bias requires humility, realism about limitations and knowledge, diversification of the portfolio, and adherence to an investment strategy based on clear rules and objectives.
Loss Aversion Bias: The tendency to prioritize avoiding losses over achieving gains, resulting in holding onto losing investments for too long and selling winning investments too quickly. Overcoming this bias involves considering the intrinsic value of investments, establishing loss and gain limits for each investment, and sticking to them without succumbing to fear or greed.
Anchoring Bias: Relying too much on initial information, even if it is irrelevant or misleading. To overcome this bias, investors should analyze investments based on current and objective criteria, compare investments with similar ones or the overall market, and avoid relying solely on historical or arbitrary references.
Herding Bias: Following the crowd and assuming that what others are doing must be correct, even with little evidence to support it. Overcoming this bias requires forming an independent and well-founded opinion on investments, avoiding influence from trends or rumors, and being contrarian when there are signs of overvaluation or undervaluation.
Availability Bias: Overestimating the probability of easily memorable events, such as recent news events, and underestimating the probability of less memorable events. To overcome this bias, investors should maintain a long-term perspective on investments, not be swayed by short-term events, and use statistical data instead of anecdotes to evaluate probabilities and risks.
Recency Bias: Assigning too much weight to recent events and disregarding long-term trends and historical data. Overcoming this bias involves maintaining a historical perspective on investments, not being deceived by short-term fluctuations, and using technical and fundamental indicators to identify investment trends and turning points.
Individual investors often exhibit behaviors that lead to suboptimal outcomes, such as underperforming benchmark indices, selling profitable investments while holding onto losses, being influenced by limited attention and past performance. Breaking these habits is crucial, emphasizing diversified portfolios, adherence to long-term investment plans, and seeking information from multiple sources.
Experienced investors understand the value of learning from past mistakes, emphasizing the importance of focusing on errors for those with less experience. A commitment to learning from mistakes accelerates the learning curve and enhances productivity for investors. Continuous self-reflection and examination of past errors contribute to long-term success in the complex world of financial markets.
References:
Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.
Recommended Readings:
Ariely, Dan. Predictably Irrational: The Hidden Forces That Shape Our Decisions. Revised and expanded edition. New York: Harper Perennial, 2010.
Thaler, Richard H. Misbehaving: The Making of Behavioral Economics. New York: W. W. Norton & Company, 2015.
Montier, James. The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy. Hoboken, NJ: John Wiley & Sons, 2010.
