Investing irrationalities
4 January 2023
Introduction
4 January 2023
Each of you knows that in the financial markets, there is never a guarantee that an event will occur, for instance, that Apple or crude oil will reach a certain price. But with analysis, you can turn the odds of success for an investment onto your side.
Why is there no certainty in the financial markets? Investors move the markets, and investors are human beings that do not always make purely rational decisions. They are often the result of emotions and feelings, and this is why there is no mathematical certainty. So, markets always have an unpredictable component.
Bernard Baruch, an American financier, stock investor, philanthropist, statesman and political consultant, once said: “what actually registers in the stock market’s fluctuations are not the events themselves, but the human reactions to these events. In short, how millions of individual men and women feel these happenings may affect their future.”
And again: “above all else, in other words, the stock market is people. It is people trying to read the future. And it is this intensely human quality that makes the stock market so dramatic an arena, in which men and women pit their conflicting judgments, their hopes and fears, strengths and weaknesses, greeds and ideals.”
Behavioural Finance is an approach to finance developed in the 70s that uses psychological and sociological studies into individual behaviour and the reasoning underlying human action in order to better understand the anomalies that occur in the financial market. This theory is based on the study of investors' behaviour in situations of uncertainty which induce the subject to make incorrect and not always rational choices.
Behavioural Finance offers a more realistic and humane interpretation of the operation of financial markets. The behaviour approach was first applied to financial markets to try and explain anomalies (Schiller 2003) and then later used to consider the set of emotions and feelings that influence market operators when making investment choices, and consequently, what affects market trends.
The traditional theory hypothesises the existence of perfectly rational and omniscient individuals who, in making decisions in conditions of uncertainty, maximise their expected utility.
Obviously, this is not reality: empirical evidence shows that individuals make cognitive and emotional mistakes that invalidate the rational behaviour proposed by classical theory. However, the traditional theoretical approach cannot be considered wrong, as it has a normative or prescriptive nature: it theorises ideal situations in the presence (theoretical, in fact) of perfect and efficient markets.
The behavioural approach, having a descriptive nature, is able to consider the limits of the rationality of individuals and then evaluates its impact on decision-making. The biggest challenge for behaviour finance is trying to demonstrate that these mistakes can be considered common to most individuals.
In technical jargon, these mistakes are called “biases.” They actually represent a predisposition to making a mistake. It is, therefore, a matter of “prejudices” in the proper sense of the term, that is, something that comes before judgment, which can lead to an error.
I will begin immediately with a very significant aspect that characterises each of us because it is true that we are all different and unique. Nonetheless, some elements are inside each of us and delineate us in full. I am talking about loss aversion. It has been proven through empirical studies that most people are more motivated by a desire to avoid a loss, than any motivation to make a profit.
This general psychological principle is linked to a survival instinct. If you think about it, it is easier to give up on a discount than it is to accept a price increase. For example, if you go to Walmart and see a T-shirt you like with a 30% discount, it is not that hard to give that discount up and simply not buy it.
But when the price of that same T-shirt is suddenly increased significantly, it is more difficult to get over it; precisely because of this mentality we all have that losses are more difficult to accept. In this case, paying more for a T-shirt that was only a few days earlier was being sold at a lower price.
I do not know about you, but it often happened to me in my first few years as a trader, that I found it difficult to accept whenever a trade went immediately into a loss. I always lived with the hope that I would be able to recover that loss sooner or later. To be clear, sometimes this did happen, but far more often the loss simply continued to increase.... and the stop-loss... I was not smart enough then to hold it at the start level, so I kept moving it higher and higher until the loss became almost unbearable.
On the other hand, when I was getting a gain, I was more inclined to take that money home too fast, out of fear that I would not make a profit. So, I would close the trade without thinking that the profit could very well have increased, maybe even by a lot. What was I doing? The opposite of what the theory tells us to do: I was running losses and cutting profits.
Below, you can see the loss aversion in a graph.
I did not draw the graph above, but it is based on empirical studies taken from samples of people, and which demonstrates how our minds are driven, when in the Losses area, to increase risk propensity, whilst risk aversion, the Gains area, is narrower. Nevertheless, as I said, people are different; some are particularly prone to this problem, whilst others are gradually able to reduce it.
This problem has a name and it is called the disposition effect. I do not know if you have heard of it, but it consists precisely of a loss aversion. Many investors tend to sell “winners” too soon, i.e., equities with a positive performance, whilst keeping the “losers,” that is, equities with a negative performance, for far too long.
Why do you think this happens? Ask yourself this question before reading on.
Let me give you an example to explain this concept better. Two weeks ago, you bought Apple shares. Today, after two weeks, the share price has dipped. Now, due to the so-called regret theory, you are led to delay your realisation of a loss because it would prove that your choice of trade was wrong. You made an incorrect decision and it is hard to swallow. Besides this, your regret increases as soon as a result has to be communicated to others, therefore you do not want to accept it.
A different situation: after two weeks, Apple shares prices have increased. In this case, you want to make a profit right now because it represents proof of your success, evidence that you were right. So, just like before, when you have to communicate the results to other people (family members, friends, other traders you are in contact with), this time, the so-called pride theory kicks in. So, there is a tendency to close the trade as soon as possible to show others your success.
With this simple example, I have explained why traders tend to hold losing trades for too long, whilst selling winning ones too soon. This is called the dispositional effect.
I understand that traders often place little weight on these aspects, thinking much more about strategies, analyses and so on. But I assure you that the more you manage to control yourself, to control all of these psychological issues, the more success you will get in the financial markets. And it is much more important to overcome all these psychological aspects than to have a better trading strategy.
The volume of research in the field of behavioural finance has grown over recent years. The field merges the concepts of finance, economics and psychology to understand human behaviour in the financial markets in order to help form winning investment strategies.
Each of you knows that in the financial markets, there is never a guarantee that an event will occur, for instance, that Apple or crude oil will reach a certain price. But with analysis, you can turn the odds of
