As a first step, let me explain how efficient markets behave. Think of supply and demand. The prices of assets adjust quickly as new information arises. New information could be quarterly earnings, the CFO leaving the company or patent approval. Anything that is linked to a company and makes economic sense. As new information comes to market, investors trade on that information and the price of the security is adjusted upwards or downwards. For every willing seller, there is a willing and informed buyer and the market clears at the market price. In other words, superior risk-adjusted returns cannot be achieved in an efficient market because the price of securities reflects all past and present information about the fundamentals of those companies.
However, though evidence suggests that markets are efficient, researchers have shown that sometimes securities can be mispriced for a longer period of time which translates into a market anomaly that can be exploited by informed traders and investment managers. Take for instance the internet bubble in the late 90s where everybody bought stocks in the tech sector because ‘it is a no brainer to do so’ or the more recent housing bubble where again ‘you had to own a house’ under those ridiculous conditions.
Now you must be confused. If we are living in a world where markets are efficient and investors make decisions after a thorough analysis, why do we still have mispriced assets and financial bubbles?
The answer is very simple: because we are all humans! And as humans we exhibit biases. Some of them are cognitive, being the response of faulty reasoning and some of them are emotional, stemming from past experiences, feelings and intuition.
For example, you are an investor who would like to trade in the stock of Apple. Based on the information you gathered and your own assessment you conclude Apple is a good company to own. The current price at which one share of Apple trades should reflect all available information about the future upside potential and as a rational investor you think you are paying the correct price. As new information comes to market you should update your forecast about Apple in a diligent and disciplined manner. You should incorporate new information according to Bayes formula and assign a probability for that event to happen. Thomas Bayes has developed this model to determine conditional probability. It relates current to the prior probability of an event.
Think of it from this perspective: the stock price will rise if interest rates fall. It means the stock will change in value if interest rates fall. Think what is the probability that the interest rates will change? You are trying to find out what is the probability the stock price will change in value and you are basing it on the probability that interest rates are going to fall. You got that probability. All of a sudden something happens at the macroeconomic level and you need to update your probability that interest rates will fall and you will also need to update the probability the stock price will change in value. This process or reassessment is done with Bayes formula. It is a way of conditioning your prior probability if new info comes out. It is simpler to use it with a decision tree.
With that in mind, you should make decisions that maximise your utility function in the aforementioned case, buying more, holding it or selling the stock. Did you follow the above process precisely? If don’t worry. It doesn’t mean you are less disciplined or less skilled than professional money managers. You have to know it is really infeasible to analyse all possibly relevant data and assign a probability to each event.
Behavioural finance assumes investors employ a combination of traditional finance and psychological biases when making investment decisions.
People are not fully in control and rational when making decisions and this is because we lack the cognitive resources of looking at every possible situation and arriving at an optimal conclusion. Instead, we have a set of goals we would like to reach. Buying a car then a house followed by a vacation house. We take things step by step and take decisions that will help us reach objectives one after another. People’s goals are based on experiences and comparison with what other people have achieved: friends, neighbours, colleagues, public persons etc. If you succeed you will adjust your goals upwards and if you fail you will adjust them downwards. This is where behavioural biases play an important role. They shape your thought process which in turn alter your decisions. And just to give you an example, think of people who already own one car per family member and want to buy another one, just for fun. From a utility point of view do they really need another one? No, absolutely not. But what drives them to go to the dealer, test-drive it and buy it? It could be explained by a lack of self-control which is a bias. The tendency to overspend current income and forgo long-term plans. Or it could simply mean that they have a lot of money and can afford to buy and to keep another car in the garage. Whichever the answer they will buy a new car. Behavioural bias attempts to explain why they make the decisions they make.
As a wealth manager and trusted advisor for high-net-worth families I have a unique opportunity to work closely with them and observe their behaviours on how they run their businesses, investments, or how they perceive risks. I will guide you in the following articles on how behavioural biases influence our day-to-day lives and how we can moderate, reduce, or even eliminate them, depending on the root cause of the bias. I am doing it because, in my professional experience of more than 6 years as a wealth manager, I have not seen any advisor or portfolio manager working with his clients from a behavioural standpoint and looking at understanding and shaping their relationship and strategy of investments taking this factor into account.