Psychology in Trading - Decision-Making Process
Decision-Making Process
4 January 2023
Psychology in Trading - The Behavioural Finance
The behavioural finance
4 January 2023

Investing irrationalities

Turbulence within the market is often not liked to any perceivable event, but rather by investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of how investors unthinkingly inflict problems on themselves.

 

Herding

That is a cardinal sin when investing, as the tendency to follow the crowd and depend on others for direction is exactly how problems arise in the market. Two actions are caused by herd mentality:

  • Panic buying
  • Panic selling

 

Holding out for a rare treat

Some investors hold onto their trades in the hopes of a reversal, whilst other investors close trades that have great long-term potential, thereby settling for limited profits.

One of the biggest ironies in the world of investment is that most investors are risk-averse when chasing gains but become risk lovers when trying to avoid a loss.

If you shift your non-risk capital into high-risk investments, you basically contradict every rule of prudence to which each market ascribes, meaning you are asking for further problems.

 

Issues

One of the most important issues in behavioural finance is whether the assumptions of investor rationality are realistic or not.

This concept can be explained with the help of an example. Let’s assume that John invests and manages his portfolio in an efficient market. Here, he has to work within seconds in response to the news. There are a great number of factors that affect John’s decisions. Further, these factors can affect each other.

How can John make the right judgements when information is updated so frequently? John probably works on a computer throughout the day, and on which a utility function program is installed for him to work. Every decision John makes is based on the calculations given by his computer. As soon as the portfolio is rebalanced, the computer's utility function program analyses new alternatives.

This process goes on and on over the course of the day. Obviously, John does not show any joy when he wins, and no panic when he loses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.

So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complexity of information received.

Psychological research has shown that the human brain often uses shortcuts to solve complex problems. These heuristics are rules or strategies for information processing, which help to find a quick, but not necessarily optimal, solution.

Once information is simplified to a manageable level, people use judgement heuristics. These shortcuts are needed to resolve decision-making as quickly as possible. Heuristics are also used to arrive at a judgement quickly; However, they can also systematically distort judgement in certain situations.

 

Simplification Bias

The first step in reducing complexity is to simplify the decision being made. However, this also runs the risk of arriving at a non-rational conclusion, unless you are very careful.

 

Mental Accounting

People focus on one account (say the purchase of share ABC) in particular when weighing things like relationships with other commitments or accounts (say the purchase of share XYZ) are usually ignored. I would like to explain this with the help of an illustration.

For instance, Company A produces bathing costumes, and Company B produces raincoats. Both companies are new, extremely efficient and innovative so that purchasing shares in these companies would be a profitable proposition.

A financial gain, however, depends to a large extent on the weather in both cases. Company A will produce huge profits if the weather is fine, while Company B will make a loss, even though this is kept to a minimum, thanks to its efficient management.

The situation is reversed in the case of bad weather. With mental accounting, either investment is risky when seen in isolation. But if we take into account the mutual effect of the uncertainty factor, i.e., the weather, then a combination of both shares becomes lucrative, and at the same time a secure investment.

 

Representativeness

That is one of the mental shortcuts that make it hard for investors to correctly analyse new information. It helps the brain organise and quickly process large stock of data, but can also cause investors to overreact to old information.

For example, if a company is repeatedly giving losses, investors will become disillusioned with this past data, and thus may overreact to past information by ignoring valid signs of recovery. Thus, the stock of the company gets undervalued because of this bias.

 

Challenges

Under the paradigm of traditional financial economics, decision-makers are considered to be rational and utility-maximising. The assumption of rational expectations is simply an assumption. An assumption that could turn out not to be true.

Behavioural finance has the potential of being a valuable supplement to traditional financial theories in making investment decisions. The following fundamentals of behavioural finance give us a glimpse of the pitfalls to be avoided. These are the challenges which need to be overcome and addressed.

  1. Hubris hypothesis: is a tendency towards being overly optimistic. It is caused by psychological biases. An investor gets swayed by the momentum generated by the markets in recent years.
  2. Sheep theory: is a phenomenon where all investors run in the same direction. They follow the herd, not voluntarily, but to avoid being trampled.
  3. Loss aversion: claims that investors take more risks when threatened with a loss. Thus, the mental penalty associated with a given loss is greater than the mental reward from a gain of the same size.
  4. Anchoring: this causes investors to underreact to new information. This can lead investors to expect a company’s earnings to be in line with historical trends, leading to possible under-reaction to trend changes.
  5. Framing: this states that the way people behave depends on the way decisions and problems are framed. Even the same problem, but framed differently can cause people to make different choices.
  6. Overconfidence: this is what leads people to think that they know more than they do. It leads investors to overestimate their predictive skills and believe they can time the market.

Knowing heuristics helps investors acknowledge where they might be susceptible, and this then helps neutralise to a certain extent distortions in perception and assimilation of information. This will, in turn, help the investor make a rational decision and get a cutting edge over the other not-so-rational investors.

More research on behavioural finance should take place not only in asset pricing but also in areas like project appraisal & investment decisions and other areas of corporate finance so that managers can avoid decision traps. Psychology and irrational behaviour matter in financial markets. Behavioural finance is relevant in many ways.

It educates investors about how to avoid biases, designing long and short-term strategies to exploit biases; and being aware that decision-makers in financial markets are human beings with biases. We also need to realise that an implicit assumption about behavioural finance is that its findings at the individual level are scalable to the market level.

Turbulence within the market is often not liked to any perceivable event, but rather by investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for

David Carli
David Carli
David is a financial analyst with over 29 years of experience (two years as a fund manager) in currencies and commodities. He collaborates with a major European commodity investment company and is the author of several successful books about trading and financial markets.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.