Practical Behavioural
Finance
Most of the standard assumptions underlying investment forecasting and
portfolio management are wrong. They fail to take into account the emotional
and psychological biases of those practicing the investment arts. Fear, greed,
risk seeking and aversion, peer group pressures all play a role in the
underperformance of many investment managers relative to their objectives.
Behavioral Finance, with its roots in the Psychological Study of Human
Decision Making, documents how and why most investment managers:
- are more confident than they should be in their forecasting ability
- do not process information efficiently
- experience the illusion of control
- do not act as if the choices they make come from a probability distribution
- make different trade-off decisions depending on the current context
- give undue credence to management and research gurus
- hang on and even add to losing positions
These psychological biases give rise to excessive trading and retention of
losing positions well after the evidence indicates that the basis for the
original investment has changed. The empirical results of this study show that
most managers underperform their benchmarks, and intuitively most investors are
aware of the facts, although the urge to deny overpowers these rational
conclusions. Underperformance is typically explained away with the use of
alternative time horizons, or by ascribing irrationality to recent investors
(ie, the market is wrong), or by confidently asserting that things are just
about to turn favourable.
Several useful suggestions have been advanced to help investors deal with
these behavioural impediments to investment success. These are:.
- Accept that investing is a probabilistic art.
- Recognize and avoid the circumstances leading to undue confidence.
- Deliberately seek out the contrary view.
- Have a written plan for each position, especially the "exit
strategies".
- Create feedback loops that allow for process analysis and improvement.
REFERENCES:
- Kahneman, Daniel, Paul Slovic, and Amos Tversky, eds. Judgment Under
Uncertainty: Heuristics and Biases, London: Cambridge University Press, 1982.
- Poundstone, William. Prisoner's Dilemma. New York: Anchor Books
(Doubleday), 1992.
- Cialdini, Robert B. Influence (The Psychology of Persuasion). New York:
Quill, William Morrow, 1984.
- Thaler, Richard H., ed. Advances in Behavioral Finance. New York: Russell
Sage Foundation, 1982.
- Hogarth, Robin M. and Melvin W. Reder, eds. Rational Choice. Chicago: The
University of Chicago Press, 1986.
- Dreman, David. Contrarian Investment Strategy. New York: Random House,
1979.
- Thaler, Richard H. The Winner's Curse, New York: The Free Press, 1992.
- Paulos, John Allen. Innumeracy, New York: Hill and Wang, 1988.
- Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New
York: John Wiley & Sons, 1996.
- Pratt, John W. and Richard J. Zeckhauser, eds. Principals and Agents: The
Structure o Business. Boston: Harvard Business School Press, 1985.
Articles/Papers
- Kahneman, Daniel and Amos Tversky. "Choices, Values, and Frames."'
America Psychologist, Vol. 39, No. 4, April 1984: 341-50.
- De Bondt, Werner F.M. and Richard H. Thaler. "Financial
Decision-Making in Markets and Firms: A Behavioral Perspective." National
Bureau of Economic Research, Inc. Working Paper No. 4777.
- Tversky, Amos, and Daniel Kahneman. "The Framing of Decisions and the
Psychology of Choice." AAAS, 1981.
A Behavioural Finance Bibliography