Behavioral finance: does our psychology move markets?

What is behavioural finance?

An emerging academic discipline that analyses how investors behave and why they make the decisions they do. Followers argue that most people do not properly understand what drives them to make particular choices and that makes the economic ideals of rational, utility-maximising investors and efficient markets essentially myths.

Instead, in deciding to buy or sell shares in a particular company, say, we are far more influenced than we think by irrelevant factors and our own psychological needs and biases. For investors, all this has obvious practical implications. If we can understand why we behave as we do, we can avoid making mistakes and make more money.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Where did this idea come from?

Arguably, it's as old as economics itself.In the 18th century, Adam Smith examined the psychological principles behind individual behaviour in The Theory of Moral Sentiments, while Jeremy Bentham's concept of utility a idea originating in political philosophy that was fundamental to the development of economics as a discipline draws extensively on psychological ideas.

In the 19th and early 20th centuries, however, most economists were eager to distance themselves from soft' psychological ideas, as they sought to gain acceptance for economics as a hard' natural science (although some seminal figures including Pareto and Keynes continued to draw on psychological explanations in their work).

And now?

In recent decades, the dominant branch of orthodox economics has been neo-classical' free market economics, which is built on the ideas of utility, rational choice theory, and efficient market theory essentially the belief that all relevant information is already factored into asset prices by the market. But at the same time, behavioural finance has gradually gained a following, both academically and in the City, where the best-known follower of behavioural finance today is James Montier. At the age of 34, he's an ex-academic economist, the author of two books on the subject, and for the past five years the global equity strategist for Dresdner Kleinwort Wasserstein.

What does Montier say?

He takes concepts and academic research drawn from psychology and applies them to investment situations. One of his core arguments is that many of the mistakes investors make stem (paradoxically) from using heuristics' the mental models we all use to make sense of complex reality.

Examples are anchoring' the use of external benchmarks to make decisions (see below) and framing', the tendency to make judgements based on how information is presented.

Another is representativeness' the tendency to judge events from how they first appear. For example, investors tend to assume that a company with strong current growth will continue to grow, whereas its earnings are more likely to revert to the mean.

Other interesting insights include the fact that people under emotional distress (such as underperforming fund managers) tend to shift towards favouring high-risk choices, and that people are much more highly motivated to avoid pain (lose money) than they are to gain pleasure (make a profit).

This phenomenon (loss aversion') explains why most investors ignore the first rule of investment to cut losses and let profits run. They cannot bear to part with a stock until it is back at the price they paid for it.

What does this mean for investors?

The main lesson is that we should not be unduly influenced by other people just because they are many or their opinions are given prominence. In practical terms, the key lesson is to use a value-based strategy that doesn't depend on forecasts of future growth; evidence suggests these are almost always wrong. "While markets get blown around by sentiment and noise, in the long run, it is valuations that determine returns," says Montier.

How else can I use these lessons properly?

Earlier this month, David Budworth in The Sunday Times drew on Montier's work to provide the following suggestions. 1) Beware information overload (the illusion of knowledge'); more information is not always better, especially as it tends to lead to overconfidence, not accuracy. 2) Most people overestimate the part their own skill has played in investment success (self-attribution bias'), and erase bad decisions from their memory. Keep a record of all your decisions, and stick to a set plan. 3) Denial people give more weight to information that appeals to them (confirmatory bias'). Beware of this kind of complacency. 4) Herd instinct people feel safer as part of a crowd, confirming their sense of self-esteem. Turn this to your advantage by picking up stocks that aren't popular with the crowd and so are cheap.

The dangers of anchoring'

One of the key heuristics' we use is anchoring' the use of external benchmarks to make decisions. In a landmark experiment (in 1974) by Daniel Kahnemann and Amos Tversky, participants were asked questions, such as what percentage of the UN is made up of African countries. Before they answered, a wheel numbered from 1 to 100, but rigged to stop at either ten or 65, was spun in front of them. When answering the Africa question, the group who had seen the low number guessed a median 25%, and the higher group guessed 45%. They were latching on to irrelevant anchors' when forming their opinions harmless in this experiment, but dangerous when forecasting future movements in share prices by looking at historic prices.