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Credence Independent Advisors

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P.O. Box 334155Dubai, United Arab Emirates.

Website: www.credence-wealth.comTel: +971 4 439 4280

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Key considerations of Behavioral Finance

Key considerations of Behavioral Finance

• The central issue in behavioral finance is explaining why market participants make systematic errors contrary to assumption of rational market participants.

• Such errors affect prices and returns, creating market inefficiencies. It also investigates how other participants take advantage (arbitrage) of such market inefficiencies.

• Some of the following traits, knows as heuristics follow.

Psychology concepts that affect the way you manage your investments.

Psychology concepts that affect the way you manage your investments.

• In psychology and more specifically Behavioral Finance, heuristics are simple, efficient rules which people often use to form judgments and make decisions.

• They are mental shortcuts that usually involve focusing on one aspect of a complex problem and ignoring others.

• These rules work well under most circumstances, but they can lead to systematic deviations from logic, probability or rational choice theory.

• The resulting errors are called "cognitive biases" and many different types have been documented.

• These have been shown to affect people's choices in situations like valuing a house or deciding the outcome of a legal case and in making financial decisions.

• Heuristics usually govern automatic, intuitive judgments but can also be used as deliberate mental strategies when working from limited information

Key considerations of Behavioral Finance

• "Investors are 'normal,' not rational" Behavioral finance reconciles the discrepancy between rational valuation and irrational market pricing.

• It's a booming field of study.

• Top behavioral finance gurus include Yale's Robert Shiller and GMO's James Montier.

• There are several common behavioral biases that drive investor decisions.

Availability Bias• Availability bias is the ease with which a particular idea can be brought to mind.

• When people estimate how likely or how frequent an event is on the basis of its availability, they are using the availability heuristic.

• When an infrequent event can be brought easily and vividly to mind, this heuristic overestimates its likelihood. For example, people overestimate their likelihood of dying in a dramatic event such as a tornado or terrorism.

• Dramatic, violent deaths are usually more highly publicized and therefore have a higher availability. On the other hand, common but mundane events are hard to bring to mind, so their likelihoods tend to be underestimated.

• These include deaths from suicides, strokes, and diabetes.

Availability Bias• This heuristic is one of the reasons why people are more easily swayed by a single,

vivid story than by a large body of statistical evidence.

• It may also play a role in the appeal of lotteries: to someone buying a ticket, the well-publicized, jubilant winners are more available than the millions of people who have won nothing.

• When people judge whether more English words begin with T or with K, the availability heuristic gives a quick way to answer the question.

• Words that begin with to come more readily to mind and so subjects give a correct answer without counting out large numbers of words.

• However, this heuristic can also produce errors.

• When people are asked whether there are more English words with K in the first position or with K in the third position, they use the same process.

• It is easy to think of words that begin with K, such as kangaroo, kitchen, or kept. It is harder to think of words with K as the third letter, such as lake, or acknowledge, although objectively these are three times more common.

• This leads people to the incorrect conclusion that K is more common at the start of words.

Investors believe they are awesome at investing

Investors believe they are awesome at investing

• Overconfidence may be the most obvious behavioral 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 under diversified and thus more susceptible volatility.

Investors are bad at processing new information

Investors are bad at processing new information

• Being poor and processing new information is known as Anchoring and 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.

Investors connect the wrong things to each other

Investors connect the wrong things to each other

• Representativeness - 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 behavioral finance concept called you incorrectly think one thing means something else.

• Another example of representativeness is assuming a good company is a good stock.

Investors absolutely hate losing money

Investors absolutely hate losing money

Investors absolutely hate losing money

• 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 behavior is similar to the gambler who makes a series of larger bets in hopes of breaking even.

• This Heuristic leads largely into another heuristic known as gamblers Fallacy, which can be best described as flipping a coin 100 times and the first 99 flips have all been tales.

• Gamblers fallacy indicates that most of us would bet on the fact the next flip has to tails. Even though the odds have not changed and as a standalone flip of a coin, the odds are still 50/50.

Investors have trouble forgetting bad memories

Investors have trouble forgetting bad memories

• How you invest your money in the future is often affected by the outcomes of your previous experience.

• 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 (Fear of regret) occurs when you avoid investing altogether or invests conservatively because you don't want to feel that regret.

• This is the human psyches was of protecting ourselves from unwanted emotions.

Investors are great at coming up with excuses

Investors are great at coming up with excuses

• Sometimes your investments lose money. Of course, it's not your fault, right?

• Defense 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.