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behavioral finance research applied to market falls and market rises supports good, profitable decisions - and helps stop the bad ones!

Behavioral Finance Consulting

Over the last fifteen years or so, behavioral finance researchers have begun to show, scientifically, that investors do not always act rationally or consider all of the available information in their decision-making process. As a result, they regularly make errors. This may seem obvious but it does, in fact, represent a radical break away from traditional economic theory which has previously considered investors as being able to make fully rational decisions and investment valuations. It turns out too that the errors they make repeat in the same way, and are, therefore, termed systematic errors. Luckily, because of this systematic character, these errors are often predictable and avoidable. Nevertheless, psychologically determined, they continue to occur frequently in stockmarkets and are made by both novice and professional investors alike.

At Psychonomics, our behavioral finance work has two directions. The first is to use knowledge from the field - about error and market functioning - as the basis of predictive models of stockmarket value in order to build investment portfolios, and a discussion about this can be found here. In essence, though, when it comes to looking at other investors, if you can predict what bad decisions they are going to make, you can capitalize on them. The second, which is discussed below, is to advise clients on whether these kinds of systematic errors are in evidence and then provide strategies to overcome them - we act as a kind of a watchdog. Simply put, you may start out using an investment approach with the best of intentions but biases, irrational motives, misperceptions, and beliefs, can lead to poor financial decisions.

Overconfidence is perhaps one of the biggest errors defined by the behavioral finance field, and which Psychonomics will often deal with. Investors and analysts are particularly overconfident in areas where they have some knowledge. However, even when steadily increasing levels of confidence are measured, this does not demonstrate any solid correlation with greater success. For instance, studies show that men consistently overestimate their own abilities in many areas including athletic skills, abilities as a leader, driving skills, and ability to get along with others. Hence, they may be very confident about their ability but this has little relationship to what they can actually accomplish above the average. Money managers, advisors, and investors, are, it seems, consistently overconfident in their ability to outperform the market, even though many fail to do so.

The fact is that while many managers are chosen on their ability to outperform the market, and this of itself provides belief and confidence in their own abilities, the real picture is not so clear. A particular manager may have done exceptionally well in a bull market and lucked out, but how will they fare during a bear run? Managers too, research shows, will often attempt to follow the choices of peers, and certainly rarely make investment decisions that are totally unfamiliar to the investment crowd. On the contrary, they stick with the 'investment herd' and the protection this affords. For example, if one well-known, senior fund manager invests in, say, the technology sector, other fund managers will follow suit. But is the decision the best one, or is it a case of one lemming following another over the cliff? Such situations have to be examined rationally in order to identify any problems before they get out of control, and again, as watchdog, we would look to work with senior executives to accomplish this.

When it comes to analysts, many professional finance people believe that company visits allow analysts to develop more confidence in their stock picking skills. There is, however, little evidence to support this assertion, as stock picking skills depend on a wide set of factors, while ability does not always equate with confidence. Nevertheless, company visits are necessary. As a result, in situations where they are used a great deal, we would seek to evaluate analyst performance in the light of any biasing effects the visits were having.

What we find as well is that full service brokers, financial advisors, as well as mutual and hedge fund professionals, are often hired despite the likelihood that they will underperform the market. Researchers, William M. O'Barr and John M. Conley, put it well in Fortune and Folly: The Wealth and Power of Institutional Investing, when they suggested that the explanation for this behavior was that brokers, advisors, and professionals, played the role of scapegoat. They concluded that officers of large pension plans hired investment managers for no other reason than to provide someone else to take the blame and that the officers were motivated by culture, diffusion of responsibility, and blame deflection, in forming and implementing their investment strategy. The theory is that they can protect their own jobs by risking the managers account. If the account underperforms, it is the managers fault and they can be fired, but if they overperform, they can both take credit.

As far as over-familiarity is concerned, this too is often an important error that we find exists in major investment institutions. Gur Huberman of Columbia University found, for example, that investors - professional as well as novice - strongly favor investing in local companies that they are familiar with. Specifically, investors are far more likely to own their local regional Bell company than the other regional Bells. The study provided evidence that investors prefer local or familiar stocks even though there may be no rational reason to prefer the local stock over other comparable stocks that the investor is unfamiliar with. In these circumstances we would examine the way investment decisions or portfolio constituents have been formulated.

The trouble is, as behavioral finance shows, people have a tendency to see their own actions and decisions as totally rational (and everyone else's as irrational), when the truth is they may not be. The results of this we sometimes see in investment companies where there is frequent trading accompanied by consistently high volumes in financial markets. On one side of each speculative trade is a trader who believes they have superior information. and on the other side is another trader who believes they also have information that is superior. Of course, they can't both be right.

Other problems that our work often reveals centers round the tendency for people to frame questions about the investment decision they are going to make in the most favourable light, when the question could just as easily be framed in a manner that would make a rational investor shy away. At its simplest level, for example, a decision to buy a long-term holding in a company can be framed in terms of questions about whether the price is right in the market, whether the management are any good, whether there is future earnings growth potential, or whether the stock makes sense for the portfolio. Some or all of these questions may or may not make sense at particular times, but would it ever make sense to base the decision on what another fund is contempating, or whether a particular manager or broker simply likes the company? Careful consideration of all the options and questions is vital before a decision is made.

Here are some other systematic errors that we often find:

  Investors may overestimate their skills; attributing success to ability they donít possess and seeing order in information or data where it doesnít exist.
  Having expressed a preference for an investment, people often distort any other information in order to add weight to their decision.
  Investors are often unable to alter long-held beliefs, even when confronted with overwhelming evidence that they should. - they fall in love with their investments, rationalize losses, or hang on too long to sell.
  Most investors will avoid risk when there is the chance of a certain gain. But faced with a certain loss, they become risk takers
  Investors are often impatient to sell a good stock
  Investors often make a distinction between money easily made from investments, savings or tax refunds and hard-earned money - found money is more readily spent or wasted
  People tend to think in extremes - the highly probable news is considered certain, while the improbable is considered impossible.
  People feel the loss of a dollar to a far greater extent than they enjoy gaining a dollar.
  Investors often take a short-term viewpoint. Recent market losses lead to suspicion and caution, while recent gains lead to action.
  Investors often assume that lack of market or price movement represents stability, while volatility represents instability
  Investors follow the crowd, and are heavily influenced by other investors or compelling news; they fail to check out the real facts
  Investors make predictions based on limited information as if they had special foreknowledge.
  Investments are often thought of as pieces of paper rather than part ownership of a company.
  Investors become obsessed with prices and trend-watching, rather than solid information.
Taken as a whole, all these errors really have only one effect, that is: a financial decision is taken that lacks accuracy. And these errors are strongest when uncertainty, inexperience, attitudes and market pressures come together to undermine decision-making ability. In this context, by virtue of our knowledge of behavioral finance and investor psychology, our aim is to help clients determine whether a financial decision actually makes sense.
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