Behavioural Finance: Force behind Capital Market Behaviour
Across the wide spectrum of the capital markets participants from stock brokers to accredited investors, the belief or what is been made to believe is that the capital markets is an efficient market, leading to “Efficient Market Hypothesis”: the stock market is efficient, and at all times the securities price reflects a sum total of all information available to public. At all times securities prices reflect their intrinsic value. For such a market, then the market should be maintaining strong fundamentals and not run on sentiments.
Notwithstanding the brutal violence for decades, the Sri Lankan bourse performed remarkably well. As claimed by a cross-section of industry stalwarts prior to 2005, we were known to be one of the best performing markets in the world if not in the region. But, a closer analysis of the listed companies reveals lackluster performance.
If so what drove the bourse to unprecedented heights pre “Chinthana Era”?.The same fundamentals that drove the market during the height of decade’s long conflict should take the post conflict market to even higher levels if the market is efficient.
File picture of the CSE.
Behavioural Finance is a discipline that applies and studies human behaviour to investment and how the market functions based on irrational investor behaviour. Perhaps, Behavioural Finance has an explanation as to why the Colombo Index dropped immediatel following 2005 Presidential elections.
As a discipline, Behavioural Finance (BF) is a new concept that has evolved in response to a vast amount of research done to understand irrational investor behaviour and study of market swings.
Traditional Finance and Behavioural Finance
Traditional Finance is based on a set of assumptions as to how the market is assumed to be efficient and provides a frame work for the rational investor to follow. Traditional Finance is driven by mathematical i.e. Black Scholes Options Pricing, and Efficient Market Hypothesis. These model based assumptions are flawed because the human brain does not work as computers do. Empirical studies done over the recent years reveals that mathematical model based Traditional Finance is flawed as the model fails to recognise external factors associated with the human decision making. Further, Traditional Finance assumes that the investor is perfectly rational and makes sound investment decisions with guidance from a frame work put in place that is driven by mathematical models.
BF is the application of psychology to finance and investment: BF factors in behavioural biases in human decision-making process. BF is built on a foundation that human decision-making process is subject to Cognitive and Emotional biases: by nature human beings are irrational. It is the irrationality of human behaviour that affects the investment decisions and the overall market performance.
Investors seek low risk and high returns. That is the industry axiom. ‘Low risk high returns’ is a departure from Traditional Finance. If one needs higher returns must one assume higher risk? Financial planners must strive to optimise the investment return for a unit of risk assumed by the risk-averse investor factoring in biases.
BF is based on observed investor behaviour while Traditional Finance is based on Idealised investor behaviour as advocated by the Efficient Market Hypothesis.
What is BF?
Simplified analogy is when grandparents decide to give a gift to their new-born grandchild:
nRs. 10,000 financial deposit for further studies OR
nRs. 10,000 as an immediate utility value to buy clothes, toys and furniture
One is a “rational decision” and the other is an emotionally driven “irrational decision”. The former is a rational economic decision based on logical reasoning as to how a reasonable thinking person is expected to behave. The other is a decision based on emotion and reflects how human emotions overpower rational thinking and influence irrational decisions. Both are assumptions satisfying different needs.
Human Emotions over Human Intellect – Dr. E.W Adhikaram
BF is more of an emotional product than a product of intellect and logic. Human emotions overpower human rationality and logic. The late Dr. E.W. Adhikaram, a prominent liberal thinker who inculcated and advocated liberal thinking among youth was also an educationist and an intellect. He formed the “Sithuvili-Samajaya”. I attended his workshops when time permitted. He acknowledged that his intellect was overpowered by his emotions at his mother’s funeral. The power of human emotions over rationality was recognised by Dr. Adhikaram long before Daniel Goldman wrote his “Emotional Intelligence”. When the “Thought” and the “Feel” is at play, the “Feel” wins.
Overview of financial decision-making process
Financial decision-making process at a micro level focuses on “loss aversion” Collect / edit data, and evaluate data. How investment risk is evaluated is subject to biases. At the evaluation stage, when the investor has a negative bias, then the investor is risk seeking. If the investor has a positive bias then the investor is risk averse. Investor focus is more skewed towards loss aversion than increasing gains.
Importance of BF
Investors when engaged in the market, have self-interest. They are not there in the market to provide job security for the stock broker or the financial advisor. The investor expects above average returns for the risk assumed by investing in the capital market. In order to achieve economic objectives, when seeking advice, the financial advisors need to know these investor biases… the key to a solid investment plan.
An Investor Bias
The term “bias”in general can be taken as a flaw in the judgement or a prejudice for or against.
As it would be applicable in terms of finance a more appropriate interpretation can be skewed investment / financial decision. Behavioural biases can be: “Cognitive” or “Emotional”.
Cognitive Biases
Cognitive biases are faulty reasoning or flaw in data and information processing and interpretation. Cognitive biases can be corrected by improving the quality of data, education and right advice.
In the case of the CPC Hedging what precipitated the colossal losses was caused by cognitive errors aside hidden agendas at a policy making level.
- Anchoring Bias:
Anchoring is triggered by irrelevant comparisons and focusing on wrong reference points. If a security was trading at a certain price point last year same time, wait for the security to reach the same price point to buy or sell the security
- Self-Attribution Bias:
Investor attributing all investment successes to their skill in stock selection skills but in the case of investment failures attributes all failures to external factors. Runs the risk of overestimating their skills after few successes but that runs counter to the overall market functionality
- Emotional Biases
Emotional biases are based on reasoning that is influenced by how they feel at a particular point in time. These biases for the most part are influenced by upbringing, beliefs, value systems, greed, fear and past experiences.
Emotional biases once recognised can only be adapted to and built into an investment plan. At times maybe the biases must be moderated in order to do a proper allocation to reach the financial goals. In 2005, the Colombo market drop can be seen as driven“emotional bias” over and above a need for “loss aversion”.
- Financial Inertia Bias:
Walks a fine line along anchoring but sets apart due to non-performance: In a loss-making investment the investor continues to hold on to loss making investment in the hope that it will reach the ideal price point that will breakeven.
-The EPF holding on to securities of loss-making entities optimistically expecting they will reach a break-even point and confident of company future potential.
- Loss-Aversion Bias
As outlined earlier, in general the investor when faced with uncertainty in the potential outcome, then the default decision is skewed towards loss aversion as opposed to profit gain. Extension to this bias is selling profitable trades pre-maturely or holding on to a losing position for too long in the hope they will bounce back.
-The Foreign Reserves Fund of the Central Bank continuing to hold on to loss-making Greek bonds is a good example of loss and regret aversion.
- Affinity Bias
Refers to the propensity to make irrational investment decisions based on how they believe or/expect a certain product to reflect its value. Focus on perceived “expressive” value and not “tangible utility” benefit.
-Investing in a company that imports milk powder without investing in the local diary industry is an example.
What the investor needs
All human beings have a need to be successful.
Universally, across civilisation what people seek and strive to achieve is success. In this pursuit, in order to be successful we all pursue an objective of material procession, in the mistaken belief that bigger bank balances, spacious houses, bigger and faster vehicles — they all bring success: emotionally driven success drivers – greed, fear, insecurities. These are symbols of perceived success. A recent study done to ascertain as to why people hoard, revealed that hoarding is driven by perceived future uncertainties and greed. I am not suggesting saving is bad. But there is a thin line that separates savings from hoarding. It was a long held belief that to be successful all you need to have is a high IQ (intelligent quotient). Later, it was argued that success is a function of EQ (emotional quotient). However, it is now widely acknowledged that success is a combination of three components and the latest add on is FQ (financial quotient)
Success = IQ + EQ + FQ
IQ – Intelligence Quotient:
Measures educational and professional achievements. Assessment of general intelligence level and ability to solve problems.
EQ = Emotional Quotient:
Combination of self-assessment/understanding and assess/understand others with mutual respect and work towards a common goal managing the final objective effectively leveraging on empathy, self-awareness Self-regulation (mutual respect) and self-motivation
FQ = Financial Quotient:
Measures the individual’s financial intelligence as to how one adopts and manages financial constraints, how risk, credit is managed, budgeting and savings are approached. Financial planning is an integral part of financial quotient.
Financial success is only one component of success. In order to achieve success, the focus thus far has been on achieving financial success.Investing/trading is one process that facilitates meeting the goal of financial success. The capital market is the tool that links the two.
We sit in front of a computer, and make trading decisions to ensure bigger yields on our investments. Decisions are emotionally driven: Greed-fear-insecurities-hidden agendas. Investment/trading decisions fail to reflect the existence of community, value development process sustainability or more importantly the nature of which the very investor is an integral part matters. In our endeavour to make large gains at lightning speed, we have created synthetic financial instruments (Derivatives) and super-fast computers that opened the door to High Frequency Trading (HFT). In the run up to be successful, driven by mistaken beliefs we invest in the system – capital markets. Overall at best the capital market is just the tip of the iceberg in our endeavour to achieve success. There are other elements that contribute to our success to be sustainable: education, value system, resilience – they all contribute to effective decision making, the very topic BF. If the system fails to recognise and support the other external factors, the system is inherently flawed. Investment’s focus is economic growth (GDP) and economic development is the process of sustainable community based development where sustainability of the nature is the key. Retirement plans (EPF) with a long term horizon must invest in the local community development projects. Any investment that disregards the nature is a failed model. We draw from the nature to find solutions to our flawed investment process.
Biomimicry – Draw from the Nature
By nature man is irrational in decision-making. Thus, as it would be applicable to the capital market realm the market performance is a function of how the collective investor thinks and that thought process is natural. Then the nature potentially has a solution and provided a natural frame work for investor effectiveness. Study of biomimicry is all about the study of nature to find solutions and draw from the nature to structure an effective framework to find solution to synthetic situations created by us.
Nature survived for billions of years:
This survival is a demonstration of “Resilience” and “Persistence” and “Patience”. For investments to grow the same approach prevails: demonstrate resilience, persistence, and patience.
Natural growth process of a seed to a fruit is a slow process as demonstrated above. In the sequence, a seed gets buried under soil that is bigger and heavier than the very seed itself. Resisting all obstacles, under the right conditions the seed will eventually reach the sunlight and then grow to be a plant bearing fruits and produce more seed. It’s the human being who messes up this natural fine balance for profit maximisation: uses chemicals and genetically modifies the seed all for yield increase as opposed to management.
Investors with unrealistic goals striving to maximise returns as demonstrated will lose on the long term. As demonstrated above the same way how a seed takes time to grow to become a fruit takes time, to reach realistic investment goals it takes time. Use simplified investment strategies that the investor can monitor. It is imperative that the risk be measurable and understood: “What gets measured gets Managed” – Drucker.
“Advisor – Investor” Relationship: Application of BF
Mandate of the advisor is to create an Optimal Investment Portfolio to reach investors’ financial goals. To meet the financial goals, an advisor-investor agreed upon investment policy is important. Investment policy factors in behavioural bias (separated emotional and cognitive), risk tolerance and wealth: level of wealth must be determined by the standard of living against the assets. If an investor has a small amount of savings but at the same time has a frugal lifestyle then the investor’s level of wealth is deemed high. For an investor with higher savings but with an extravagant way of life such investor’s wealth will be considered low.
The assessment of level of wealth can be seen as subjective but that bit of information is important in the asset allocation process. Once all the behavioural biases are accounted, the biases can be adapted or moderated as deemed suitable and then the advisor processes the best asset allocation (behaviourally modified asset allocation) to help the investor reach financial goals.
(The writer is a financial markets specialist basedin Canada)