EquitiesJul 14 2014

The vagaries of the human mind

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Human nature, and in particular, the human mind, is a complex and wonderful thing. So is the human decision-making process.

While this should involve an objective analysis of the facts, in practice the way in which decisions are made can be extremely subjective.

Behavioural finance aims to explain why people make the financial decisions they do. After the events of the financial crisis in 2007/08 it is seen as a field of particular relevance, although it has been a recognised area of financial analysis for many years.

In a booming field of study, top academics such as Robert Shiller, James Montier, Dan Kahneman and Amos Tversky have led the way. Normal people sometimes behave irrationally – that is part of life, and indeed, that is part of what makes life so interesting.

Here are the most prominent types of behaviour.

Optimism bias

Investors tend to be overly confident in their judgement because their subjective confidence is usually greater than their objective accuracy. This can be illustrated (somewhat worryingly) by the responses of four out of five car drivers who, when asked, considered their driving skills above average. Investors are more likely to believe in their own subjective views than other possible outcomes.

Loss aversion

Investors feel losses more strongly than gains by a factor of more than two. So the negative effect, felt as regret or financial pain, of losing £1,000 is over twice the positive effect, felt as satisfaction or financial pleasure, of gaining £1,000. Fear of losing money leads to inaction over action and the continuation of the status quo. This appears to contradict the notion of optimism bias but, in reality, they can operate simultaneously – the decision can be headstrong while the choice can be feeble.

Confirmation bias

Investors often start with a conclusion and then back-fill with the necessary supporting facts and figures to support the conclusion. This is known as confirmation bias. The conclusion is allied to the investor’s view at the outset and helped in its formulation by the investor giving more weight to confirmatory evidence than conflicting evidence.

Self-serving bias

This derives from aspects of confirmation bias and optimism bias. Self-serving bias allows us to think that positive outcomes are a result of the investor’s own input, while negative outcomes are beyond their control.

Choice paralysis

Investor choice is seen to be a good thing – however, the greater the choice, the poorer the investor’s ability to decide. Extensive choice often leads to decision paralysis due to the weight of information required for proper analysis.

Herding

Too often, investors put aside an objective conclusion and give too much weight to the decisions of the majority. They follow other investors, the herd. The investment decision should stand on its own merits.

Recency bias

Too often the recent past is viewed as being a tether of reality from which the forward-looking hypothesis should develop. The past performance of individual investment provides context and hard information, but does not dictate the future performance.

Anchoring

Anchoring is related to overconfidence, but also founded in past information and, to a degree, recency bias. Investors might make their initial investment decision based on the information available to them at the time. Later, when they receive new information that affects their initial assumptions, rather than produce a new analysis, they just revise their old analysis.

Frame dependence

This is a concept that recognises the tendency to exhibit a changing risk tolerance prompted by changes in the direction of the market. For example, willingness to tolerate risk may fall when markets are falling or rise when markets are rising; often causing the investor to buy high and sell low – precisely the wrong result.

So what use is behavioural finance? Well, when investors encounter these situations, they need to slow down, exert self-discipline and contemplate some of the behavioural pitfalls.

Mark Rushton is chief investment officer at Walker Crips stockbrokers