The 8 Key Concepts of Behavioural Finance

Behavioural Finance

The key concepts of behavioural finance studies why humans make irrational decisions when it comes to investing. It seeks to combine human psychology and traditional finance. It explains why the majority of investors lose money, including myself. This an interesting field of study and the lessons learnt can provide some practical value to your investment journey. The 8 concepts are:

  1. Anchoring
  2. Overreaction and the Availability Bias
  3. Mental Accounting
  4. Confirmation and Hindsight Bias
  5. Gambler’s Fallacy
  6. Herd Behaviour
  7. Overconfidence
  8. Prospect Theory & Loss Aversion

1. Anchoring

Anchoring is when investors make reference to a price point that is irrelevant. For example, the selling retail price of a car is $300,000. It is now selling at $240,000, a $60,000 discount from the original price. The buyer felt that he has made a good deal as he used $300,000 as his anchor point. However, $240,000 may not necessarily be a reasonable price as the seller can mark-up significantly higher than the cost of the car.

In investing, we often make reference to the 52-week high or 52-week low as our anchor point. When a stock falls 40% from its 52-week high, we take it as its a bargain buy without considering the possibility that the price at its 52-week high is highly overvalued. Anchoring relates to relative valuation. We make the reference to the current price based on something, which may or may not be accurate, or even irrelevant.

We tend to use past lows and past highs as anchor points. When the price breaks below the low or above the high, we struggle to find something to base our judgement on. The effect of anchoring bias can sometimes lead to the cause of “post-earnings drift”. This is when the market underreacts to the news. For example, when a positive earnings report came out, the share price drifts around before making higher highs only after weeks or months. It is as if everyone is afraid and the collective sentiment is taking time to adjust the new anchoring point.

The key to avoiding anchoring bias is to practice absolute valuation or value investing. This is when you calculate the intrinsic value using Discount Cash Flow (DCF) analysis, independently from any anchoring prices. The challenge of this is the assumptions and inputs that are being used in the valuation model. This is often the case when we attempt to extrapolate data out 10 years ahead. There might be an anchoring bias on past financial figures that do not reflect the traditional course of a company’s business operations.

2. Overreaction and the Availability Bias

Investors tend to overreact on the news, which ends up creating a disproportionate effect on share prices. One perfect example is when the fed is hinting to raise interest rates. All the REITs counters tanked as people thought that higher interest rates mean higher financing costs and lower DPUs. In reality, history has shown us that there is little correlation between the impact of rising rates and REITs’ performance.

Another one. The US-China trade war; slapping tariffs on one another, exchange of angry tweets and threats to one another. This news and uncertainty led to a minor sell-off of banking stocks in Singapore. Share prices of DBS, OCBC, UOB tumbled down, only to see them bounce back up quickly after a few days. These are the cases of the market overreacting and it usually signals a buying opportunity for investors.

Availability bias is when our decision-making process is strongly influenced by events closest and most available to us. The most classic example is this. What causes more death? Shark attacks or falling aeroplane parts? Most people would rate shark attacks as we can easily recall images of shark attacks from movies and mainstream media. The surprising truth is that the chances of dying from falling aeroplane parts is 30x higher than from shark attacks.

Another example. A person who got robbed before or has items lost while on an overseas trip is more likely to buy premium travel insurance. This is because the events are available, vivid and recent to them. But if you ask someone who didn’t experience such trauma, they would be more inclined to save on that cost.

In Investing, someone who has lost money in the stock market through an economic crisis would be more risk-averse than a beginner. My case is a good example. I started investing in crypto early 2016 and I caught the entire rally up till late 2017. In 2018, I lost it all. This experience has made me more risk-averse and prudent with my capital. I stopped pumping in $ to crypto. BUT, the fact is crypto is already through the recovery phase and its at the start of a bull cycle. The time when I decided to stop buying is actually the best time to buy. But the memories of losing $ in crypto suggests otherwise. What if I lose more? Capital preservation is of utmost importance. Rule No.1: Don’t lose Capital and so on.

3. Mental Accounting

Mental accounting is a behavioural bias that causes one to separate money into different categories based on different mental accounts. It causes us to think differently about money either based on the source of money or the intention of the money. To illustrate, take the following quote for example.

“Mr. and Mrs. L and Mr. and Mrs. H went on a fishing trip in the northwest and caught some salmon. They packed the fish and sent it home on an airline, but the fish were lost in transit. They received $300 from the airline. The couples take the money, go out to dinner and spend $225. They had never spent that much at a restaurant before.”

— Richard H. Thaler (2008)

They treated the $300 as a windfall gain and put them into the food account. The reasoning is that this money was never mine, let’s treat ourselves to a free dinner and enjoy the food.

Another example. This is the Kahneman and Tversky (1984) classical theatre ticket experiment. which one would you have paid extra for the tickets?

Case 1: You bought a ticket for $10. Before you went in the movie theatre, you lost the ticket. Would you spend another $10 to purchase another ticket?

Case 2: While walking to the movie theatre to buy a movie ticket, you lost $10. Would you still buy the movie ticket?

The experimental results revealed that people wouldn’t pay extra in case 1 but would pay extra in case 2. In both cases, the total loss was $20. But why would we pay extra for case 2 but not in case 1?

This is because in case 1, we have a mental account of the movie ticket. To pay extra means the same movie ticket would have cost $20, which is a bad deal. However, there are 2 mental accounts in case 2. One is the movie ticket and the other is our personal wallet. The movie ticket account is $0, the personal wallet account is -$10. Paying an additional $10 for the movie ticket is still acceptable. The movie ticket account now becomes -$10 and the personal wallet account remains at -$10. We don’t get the feeling that the movie ticket costs $20.

In personal finance, it is likely that the $600 we earned from our salary and the $600 we get from the government’s GST voucher is being treated differently. In the latter case, we are more inclined to take on higher risks. However, the $600 that we painstaking earned is more likely to be spent prudently. This is known as the trophy effect. We ascribed a higher value to the things we worked hard for.

This is how the sources of money affect mental accounting. Even though both the $600 are equal in value, we treat them differently because the way they are derived is different. One is through hard work while the other one comes at no cost.

Another example. Imagine both parents set up a special savings account for their child’s future education. The interest earned on this savings account is 2% a year. They diligently set aside 20% of their salary towards this special savings account. At the same time, they have credit loan debts that the bank charges them 15% a year.

The wiser decision would be to focus on paying down their debts so that the interests saved can go towards the child’s education fund. However, most parents would place a higher priority on their child’s future rather than on their personal debts. The money that is spent on the child is more important than the money that is spent on paying the banks. Hence, more money goes towards the special savings account rather than repaying the debts. This is how the intent of money affects our mental accounting and the way we make decisions.

To avoid mental accounting, we should see every dollar as fungible and equal in importance. It doesn’t matter the source of money or the intent of money. Money is money and we shouldn’t treat them differently based on our bias thinking. It all starts with being aware and conscious of how we sometimes make poor financial decisions due to mental accounting.

4. Confirmation and Hindsight Bias

Confirmation bias is best described by Daymond John from Shark Tank. A jury convicts you or exonerates you within the first 30 seconds of seeing you. All they do after that is to listen to the things that prove what they are thinking about you is true. Even though the point he is trying to drive across is the importance of the first impression, confirmation bias happens everywhere in our daily lives.

We tend to selectively filter out and pay more attention to the things that support our preconceived ideas and opinions. Anything that is contrary to our views is often ignored and rationalised. You don’t have to look far to understand this. Arguments among couples or discussions in corporate meetings always have these confirmation bias issues.

The danger in investing is when the internet floods you with a hot stock pick. Prices are bullish and you went on to research more about this stock. More often than not, the FOMO effect has already set in and we are just looking for confirmations to justify our investment decision. Such a one-sided view of information can be dangerous as we tend to ignore the red flag or risks of the company.

Hindsight bias is a tendency to see the past as being predictable and explainable. The truth is information now and information then is completely different. That’s why it is so important to keep a trading journal. I would often write down the reasons and my thought process before entering a trade. This allows me to keep any hindsight bias in check. I wouldn’t feel so bad or regret if the trade turns sour. This also helps me to learn from my mistakes more objectively.

5. Gambler’s Fallacy

Imagine you are betting a game of heads and tails. The outcome is “heads” for 6 times in a row. Would you bet head or tail on the 7th round? The gambler’s fallacy theory states that we are more likely to predict “tail” on the next outcome. This is because it is impossible to have “heads” consecutively for so many rounds. The truth is in every round, the chances of getting a “heads” or “tail” are always 50-50. The probability shouldn’t be based on past results.

Another example. Imagine you are playing blackjack with the house. The house has won 4 times in a row. You thought to yourself, he can’t be winning consecutively, now is the time to double down on my bet. End up you lost again. Every round is supposed to be independent, but we use past results to predict the future. This is known as the gambler’s fallacy theory.

In investing, we make the same mistake. If a stock is on a sell-down and there are 9 red candlesticks in a row on the daily time frame, you would think that reversal is around the corner. Then we buy in and we caught the falling knife. Similarly, when the stock has gone up significantly over the past few days, we sell and locked in some profits. Then the stock continues surging strongly up ahead and you missed out on the next wave of the rally. You sell because you think prices are expensive relative to the past. He buys because he thinks prices are cheap relative to the future. Bitcoin is one good example. This rocketship waits for no man.

To avoid gambler’s fallacy, it is important that we do not make investment decisions based on past events. It is better if we do up our fundamental research as of today and look forward to the prospects of the future. All previous price actions should not play a significant role in the analysis. This is somewhat like momentum investing. Buy high, sell higher. In evaluating whether the current price is right, the future should be more important than the past. Compare the current price with the future, NOT the past.

6. Herd Behaviour

This is a classic in Singapore. You see herd behaviour everywhere. When people queue up for some stuff, everyone went along and queue with them. Since the queue is long, the food must be good or the freebies must be worth it. Herd behaviour happens in the financial markets too. When everyone buys something, they think the stock must be good, it can’t go wrong since everyone is buying. Herding is often the cause of exuberance, overvalued assets and a bubble.

Sometimes it can be because of asymmetrical information. People know something that you don’t, that’s why volume and prices are spiking up. However, sometimes such actions can be likened to the greater fool theory. Everyone buys not knowing why and there will always be a greater fool that is willing to pay more than the price today.

Herd behaviour is like the collective wisdom of the crowd. Everyone thinks the same way, shares the same optimism and you feel safe & secure with the crowd. The investors who make a ton of money are those contrarians that go against the herd. Most of the time, the herd is right but sometimes they can be wrong. Most of the people who bet against the crowd are wrong, but those who get it right are the legends.

For example in the movie, The Big Short, Michael Burry discovered that the sub-prime mortgage loans were extremely risky in 2005. He wanted to short against them, but there were no derivative instruments back then. Everyone thought mortgage payments were 100% secure, they were rated grade AAA and the mortgage bonds were selling like hotcakes. He went on to investment banks to propose a Credit Default Swap (CDS) instrument, first of its kind, which is like insurance if these bonds defaults. He saw something that the whole world didn’t. Investment banks were laughing at him. The chances of mortgage bonds defaulting are practically close to zero. Banks were earning free and easy money from the premiums of these CDS. The firm was losing capital fast and clients threatened to sue him. In 2007-2008, the crisis happened. He bet against the crowd, stood firm in his conviction and profited $2.69 billion.

More often than not, it is usually the worst time to invest when the herd comes. That is usually the time when you are ready to sell, not buy. Making money often involves doing the opposite of what the herd does. If you follow most people, you would most likely end up getting the same results as most people, which is mediocrity. But again, most of the time contrarians are wrong and that is why so few people make it big in investing.

7. Overconfidence

Investors become overconfident of their abilities when they are on a winning streak. They felt like they have the uncanny ability to hand-pick selective stocks, beat the market and make a huge ton of money. We overestimated our own skills and underestimate the risks involved.

This usually happens in a trending market where almost everyone makes money. They fall into this illusion of being able to control or influence events that they have little control over. They think that they can get in and out the market at the right prices, shift assets around, buy, sell, buy, sell, thinking that their strategy is right. The end result is over-trading, wrong moves and diminishing returns from all the various transaction costs.

This is dangerous as the more overconfident we get, the more risks we take. You will see this everywhere not only in investing but also empires and civilisations. Hyman Minsky famously observed that “stability begets instability”. When empires become mature, stable, powerful, it is also the time they become complacent. That is how the Shu state from three kingdoms lost. That is how the Ottoman Empires lost when the Janissaries became corrupt and indulge in luxury.

The way to avoid overconfidence is simply to stay humble and realise that you are not as smart as you think. Paul Tudor, a billionaire trader, once quoted in the book “Market Wizards: Interview with Top Traders.”

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead…”

-Paul Tudor

When your trades are successful, don’t get too overconfident. Always balance out aggressiveness and defensiveness in a prudent way. Think about what could go wrong and don’t let the ego get over your head.

8. Prospect Theory & Loss Aversion

The prospect theory states that humans value gains and losses differently. We are more likely to sacrifice additional gains for certainty. “A bird in the hand is worth two in the bush.” Imagine these 2 cases, which would you have chosen.

Case 1: Guarantee win $10,000
Case 2: 75% chance to win $14,000 and 25% chance to win $0

Most people would have taken that $10,000 and walk away. Don’t be too greedy, what if you walked away with $0? We prefer certainty.

Now let’s talk about how we perceive losses. A unit of loss has a higher emotional impact than a unit of gain. If we put them on a graph, it would look something like this.

Image result for loss aversion

We feel more pain if we lost $0.05 than we feel happy if we gained $0.05. The pain of losing $100 is more than the joy of making $100. Imagine these 2 cases, which one would you have chosen?

Case 1: Guarantee lose $200
Case 2: 50% chance lose $400 and 50% chance to lose $0

Most of us would have taken the risk in case 2. This is known as loss aversion. We don’t want to lose and we are willing to take the risk to avoid losing. But when it comes to gain, we want certainty and we avoid the risk of making higher gains but potentially winning $0.

The prospect theory explains the disposition effect. The disposition effects state that investors treat paper gains and paper losses differently. Investors have the tendency to realise paper gains more quickly, but delay or even avoid realising paper losses. They tend to hold on to losers and sell winners.

The reason is that we want the losers to break-even before even considering selling. It is hard to accept that we are wrong on a trade and we lost money. A unit of loss is PAINFUL and we want to avoid that. We rationalise to ourselves that it is all just paper losses, prices would come back up. We are willing to take additional risks to lose MORE or lose nothing. (as shown in case 2) This is what I told myself exactly. It is either I lose all on crypto or I make a huge gain out of it. HODL, HODL & HODL…

The disposition effect is probably one of the primary reasons why most investors don’t make money. They are unwilling to realise paper losses, hence their portfolio continues to decline. They realise paper gains too quickly, end up missing all the gains in the rally ahead. We would be better off if we did the reverse opposite. Sell losers and hold winners. Not sell winners and hold losers. It just doesn’t make sense, but that is how the psychology of behavioural finance screws us up.

Closing Thoughts

In the world of investing, emotions run high. This is because money is involved and money is an emotional subject. Academic financiers have emphasised theories on modern portfolio theories and the efficient market hypothesis. But they failed to explain why the internet bubble happened, why the 08 housing crisis happened, why the crypto bubble happened. The study of behavioural finance and human psychology in finance has gained significant importance and appreciation from the industry.

Being consciously aware of our own irrational actions in investing is the first step towards becoming a better investor. It allows us to stop and think, to practice critical thinking and to realise that we might fall into the traps and pitfalls of such thinking fallacies. Anything that deals with the neurological pathways of the brain are definitely not easy. But looking at it objectively can help to eliminate and mitigate these biases from clouding our judgement.

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