Financial theory in the traditional sense assumes that investors act rationally, using all available information to make investment decisions. If we also assume that markets are frictionless (no tax and no costs), we should have a situation where markets are perfectly priced. What you pay for a stock should be what it is worth. In accounting terms, a company must equate their assets (minus liabilities) to their equity – the result of which represents the company’s book value. Book value is not to be mistaken with market value.
These two values almost never match. Behavioural finance challenges these assumptions in order to unlock how individuals and markets actually behave.Behavioural finance in this sense attempts to identify how irrational decision-making impacts markets. How much of market behaviour is actually attributed to variables such as feelings, subjective reasoning or even cognitive errors? In this article we focus on emotional bias in the marketplace.
Emotional bias can lead us to believe in things that make us feel good even if they are not true. When it comes to stock markets, emotional bias can hinder our ability to make rational investment decisions, causing us to follow our intuition instead of making informed, unbiased decisions. This intuitive feeling is likely to be perceived as rational by a particular investor; however, in reality it might not be. This contradiction in thought often leads to suboptimal investment decisions.
Michael Pompian is the founder and CIO at Sunpointe Investments, and also the author of Behavioral Finance and Your Portfolio. Pompian refers to numerous emotional biases evident in the marketplace. It must be noted that besides emotional biases, behavioural theorists have also attributed faulty cognitive reasoning as a factor that may explain irrational decision-making in the marketplace. Cognitive errors are based on statistical, information-processing or memory errors, whereas emotional errors arise from feelings and are often more spontaneous in nature.
For this article, we focus on a handful of the most common biases we often witness from our clients and illustrate their potential impact on decision-making by way of a hypothetical scenario. The four biases that we address are as follows:
• Loss aversion bias
• Herding bias
• Confirmation bias
• Overconfidence bias
The hypothetical investment scenario:
- We consider an individual who invested N$200,000 equally into two stocks: N$100,000 into stock A and N$100,000 into stock B.
- After one year, stock A has appreciated in value toN$150,000, while stock B has depreciated in value to N$50,000.
- The investor is now faced with a financial emergency where they need to liquidate a portion of the portfolio equivalent to N$50,000.
Think about how you might go about doing this and then ask yourself if you may experience any of the following emotional biases / cognitive errors.
Loss aversion bias: This bias refers to the tendency to prefer avoiding losses over acquiring gains. In this scenario, the investor may be more focused on the loss they would incur by selling stock A. As a result, the investor may choose to sell stock A even though it has appreciated in value, to avoid the perceived loss of selling stock B at a lower price.
Herding bias: This bias refers to the tendency to follow the crowd and make decisions based on the actions of others. In this scenario, the investor may be influenced by the market sentiment and choose to sell stock B because it has depreciated in value, even though it may not be the best long-term decision.
Confirmation bias: Confirmation bias is the tendency to seek out and interpret information in a way that confirms pre-existing beliefs. In this scenario, the investor may have a bias towards a particular stock and seek out information that affirms their bias to sell the other stock based on their pre-existing beliefs, rather than to perform an objective analysis of the current market conditions.
Overconfidence bias: Overconfidence bias refers to the tendency to overestimate one’s abilities and the accuracy of one’s beliefs. In this scenario, the investor may be overconfident in their ability to predict future market movements and may make investment decisions based on their assumptions rather than objective analysis. This is similar to the illusion of control bias where an investor is likely to trade more than is prudent based on often unwarranted illusions of their ability to predict certain outcomes. This also often leads to inadequately diversified portfolios, as evidenced in the scenario, and is a huge concentration risk given the portfolio is made up of only two stocks.
As briefly illustrated above, cognitive and emotional biases can significantly affect investment decisions and lead to suboptimal outcomes. The first step in correcting a bias is recognising that the bias exists and labelling it as such. The purpose of this article is to raise awareness and to assist investors in recognising their own biases in order to make more informed investment decisions going forward. A qualified wealth manager may assist further in the process of removing as much bias from investment decision-making as possible.
Article by William Rudd, a senior portfolio manager at IJG, an established Namibian financial services market leader. IJG believes in tailoring their services to a client’s personal and business needs. For more information, visit www.ijg.net.