Since the mid 1950s, the field of finance has been dominated by the traditional finance model, which is based on the idea of investors making rational investment decisions and applying unlimited processing power to any available micro and macro data. However, the stock market is often said to have a personality of its own, which is a result of investors’ emotions and irrational expectations. Behavioural finance describes how investors make decisions to buy or sell stocks based on emotional and psychological impulses.
There are three key differences between traditional finance and behavioural finance. In traditional finance it is assumed that: i) investors have a general preference for certainty over uncertainty (risk aversion); ii) data is processed appropriately and correctly without being biased (rational expectations); and iii) focus is given to a single asset’s risk - return profile but also on how that asset relates with other assets in the portfolio (asset integration).
On the other hand, behavioural finance assumes that investors: i) prefer carrying larger uncertain losses rather than smaller certain losses (loss aversion); ii) employ imperfect rules of thumb to process data which induces biases in their beliefs and predispose them to commit errors (biased expectations); and iii) focus is placed on an individual asset and not the portfolio as a whole. This leads to increased overall risk due to the lack of portfolio diversification (asset segmentation).
One will find a plethora of investors’ profiles in behavioural finance. Anchoring and adjustment and aversion to ambiguity are two of them: 1) Anchoring and adjustment. Investors often form an opinion about a company and are unwilling to change it, even though they receive new relevant information, such as annual financial reports, which might show lower earnings than expected. Investors will persist in the belief of their original analysis and will not react sufficiently to the bad news.
2) Aversion to ambiguity, which can also be described as “fear of the unknown”. Investors are wary of stocks they’ve never heard of (even if these are cheap) and would prefer stocks which are more familiar to them (even if these are expensive). We often notice this in Malta where normally local investors prefer local stocks since they can easily relate to the company and hence feel a certain affinity to their investments.
“Fear of the unknown” could also result in “mental accounting”, where investors’ structure their portfolios like pyramids, as can be seen above:
In the first two layers from the bottom we find investors who are looking to fund important financial commitments such as a home loan or their children’s school fees and hence have low tolerance to investment risk (corporate/government bonds, cash deposits). Assets are normally very liquid and can be accessible at any time. Once this level is established, investors keep on adding layers. With each successive layer added, investors increase their appetite for risk as each layer represents different and possibly less important goals.
The third layer of such an investment portfolio would be made up of riskier investments (when compared to the previous two layers) with a longer term investment time horizon and potentially higher rates of return (equity). Finally reaching the fourth level, investors look for even longer term investments with an even higher risk return profile (venture capital). Less risk averse investors will be most interested in this top level, where such investments may yield large gains but may also wipe out all the invested capital.
The size of each layer (in the pyramid) within an investment portfolio may also be influenced by the personality of the investor, apart from his current stage in the life cycle, which results in different attitudes and styles of investing. There are four personality types: Cautious investors make decisions based primarily on feelings and are very sensitive to investment losses. Furthermore, these investors base their investment decisions on feeling and gut rather than on fundamental analysis. Fear drives their investment decision making process; hence a secure savings account will be the obvious choice.
Methodical investors make investment decisions based on hard facts and rely heavily on investment research and are not emotional about their investment decisions. Conversely, spontaneous investors make investment decisions based on feeling and make them frequently. Such investors are always on the look out for the “hot” stocks, like to trade their investment positions very frequently and are ready to invest in high risk-return stocks. Individualist investors make decisions based on hard facts and do not second guess their investments often. They exercise independent thinking and put a great deal of trust in their investment research. By combining the older ideas of traditional finance with the newer thinking of behavioural finance, we believe we can counteract emotional decisions for the benefit of the investor’s portfolio. Remember that if you run with the herd, you might get trampled.
This article has been prepared by Diandra Muscat, a client manager at Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
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Ms Muscat is a client manager at Curmi & Partners.