Investors can be strange creatures. We wait until the market has risen before we are willing to buy. We sell when the market has plunged. Worse still, we hold on to a floundering stock, waiting for it to regain the price that we paid for it.
- Why do we panic when markets drop, even though we knew it was going to happen?
- The study of behavioural finance continues to attract attention
- Increasingly, asset managers are using pricing models to take behavioural biases into account
Investors can be strange creatures. We wait until the market has risen before we are willing to buy. We sell when the market has plunged. Worse still, we hold on to a floundering stock, waiting for it to regain the price that we paid for it.
“Why do we behave irrationally?”
Why do we behave irrationally? Why do we wait for validation from others before we are prepared to make a move? Why do we panic when markets drop, even though we knew it was going to happen? And why do we become attached to lame ducks, when selling them and moving on would give us a chance to recoup our money elsewhere? Many theories abound: if we look back as far as the 18th century, economists such as Adam Smith were seeking explanations for the behaviour of individuals and markets. More recently, the study of behavioural finance has gained mounting levels of interest.
Increasingly, asset managers are using pricing models to take behavioural biases into account, as they believe it gives them an advantage. Behavioural finance suggests that people often make decisions based on so-called rules of thumb, rather than on rational analysis. It explores the theory that the way a problem is presented can affect the outcome (a process called “framing”). This suggests that market inefficiencies are not the only way to explain outcomes that fly in the face of rational expectation.
Two of the most influential psychologists in the field are Daniel Kahneman and Amos Tversky. In 1979, they published a paper comparing models of rational economic behaviour with decision making during times of risk and uncertainty. This paper – Prospect Theory: an analysis of decision under risk – sought to explain anomalies in the way investors and financial markets react.
These theories help to explain why many investors were pulled into phenomena such as the technology boom (too late, in many cases, to make any real profit), despite the irrational theories that tend to support the investment theses. They explore why we continue to avoid markets that have underperformed in the past, despite clear signs of future long-term potential. They also help to explain why we become emotionally attached to some investments long after they have started to go wrong, and why we lose our nerve and sell out of a falling market at the moment when our loss is at its greatest.
