Thousands of ambitious financial analysts around the world will sit for one of the three the Chartered Financial Analyst (CFA) exams this weekend.
The very few candidates who are taking the level III exam will be tested on a fun topic: behavioural finance.
“Investors are ‘normal,’ not rational,” says Meir Statman, one of the leading thinkers in behavioural finance.
behavioural finance reconciles the discrepancy between rational valuation and irrational market pricing. It’s a booming field of study. Top behavioural finance gurus include Yale’s Robert Shiller and GMO’s James Montier.
We compiled a list of the seven common behavioural biases that drive investor decisions. Read through them, and you’ll quickly realise why you make such terrible financial decisions.
NOTE: These definitions are derived from Hersh Shefrin’s Beyond Greed And Fear, which was required reading in the CFA Institute’s Level III curriculum in 2009.
Overconfidence may be the most obvious behavioural finance concept. This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.
Overconfident investors are often underdiversified and thus more susceptible to volatility.
Anchoring is related to overconfidence. For example, you make your initial investment decision based on the information available to you at the time. Later, you get news that materially affects any forecasts you initially made. But rather than conduct new analysis, you just revise your old analysis.
Because you are anchored, your revised analysis won't fully reflect the new information.
A company might announce a string of great quarterly earnings. As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad behavioural finance concept called representativeness: you incorrectly think one thing means something else.
Another example of representativeness is assuming a good company is a good stock.
Loss aversion, or the reluctance to accept a loss, can be deadly. For example, one of your investments may be down 20% for good reason. The best decision may be to just book the loss and move on. However, you can't help but think that the stock might comeback.
This latter thinking is dangerous because it often results in you increasing your position in the money losing investment. This behaviour is similar to the gambler who makes a series of larger bets in hopes of breaking even.
How you trade in the future is often affected by the outcomes of your previous trades. For example, you may have sold a stock at a 20% gain, only to watch the stock continue to rise after your sale. And you think to yourself, 'If only I had waited.' Or perhaps one of your investments fall in value, and you dwell on the time when you could've sold it while in the money. These all lead to unpleasant feelings of regret.
Regret minimization occurs when you avoid investing altogether or invests conservatively because you don't want to feel that regret.
Your ability to tolerate risk should be determined by your personal financial circumstances, your investment time horizon, and the size of an investment in the context of your portfolio. Frame dependence is a concept that refers to the tendency to change risk tolerance based on the direction of the market. For example, your willingness to tolerate risk may fall when markets are falling. Alternatively, your risk tolerance may rise when markets are rising.
This often causes the investor to buy high and sell low.
Sometimes your investments lose money. Of course, it's not your fault, right? defence mechanisms in the form of excuses are related to overconfidence. Here are some common excuses:
- 'if-only': If only that one thing hadn't happened, then I would've been right. Unfortunately, you can't prove the counter-factual.
- 'almost right': But sometimes, being close isn't good enough.
- 'it hasn't happened yet': Unfortunately, 'markets can remain irrational longer than you and I can remain solvent.'
- 'single predictor': Just because you were wrong about one thing doesn't mean you're going to be wrong about everything else, right?