The first concept to be familiar with is that the behavior of rational economic agents leads to efficient markets, but are agents rational?
Do you believe that every investor in the world has access to perfect information, perfect timing, and the absolute skill to deal with the information in the correct way?
I’m betting on no. Whenever there is money to be made, irrationality looms around. Behavioral finance tries to explain some phenomena we see every day in the markets. It presents some biases that seem to inflict most of us due to our human nature and that is one of the reasons that robots are doing the trading now. Basically, biases are divided into two parts, cognitive and emotional, with the former dealing with judgement mistakes and the latter with emotional slips. Starting with cognitive biases we can discuss the most common ones to keep in mind:
Conservatism is when a trader is slow to react to new information and places too much weight on base rates. The way to deal with this bias to force one’s self to be skeptical of her basic analysis and to be always dynamic and ready for change. The market does not look too far into the past.
Confirmation bias is when the trader focuses on positive information and dismisses negative information. This is by far one of the most common ones and it is actually a normal state of mind that leads to overconfidence. By positive information, I mean the ones that seem to support the trader’s initial view. So, if the trader is bullish, she will only look at positive news on the stock and disregard any bad news on the company.
Representativeness is where the inflicted is very fast to react on new information with no regard to past information. The key here is to balance the decision-making process and to try to objectify it as much as possible.
Illusion of control bias can lead to concentrated positions due to a sense of power over the invested asset. It can be due to a weak liquidity stock. This tends to be more common with penny stocks rather than enormous markets such as FX and commodities.
Hindsight bias makes the inflicted overestimate her past accuracy and can lead to excessive risk taking. The majority of predictions are made with hindsight. This means that we can all look at past charts and conclude that the future direction was to predict. Most back-tests also suffer from what is known as look-ahead bias which is the hindight equivalent of a systematic machine strategy. It is simply defined as the fact of including data that happened after the prediction point making it unrealistic.
Anchoring bias is where one does not change his original forecast or research even when new information comes out. As I have mentioned, the analyst or trader must always be dynamic. After all, the market is always dynamic and changing properties.
Mental accounting bias is when investors construct layered portfolios and suffer from suboptimal diversification due to a lack of consideration for the correlations. It can be tempting to construct a segmented portfolio but from a portfolio management point of view, this hurts more than it helps.
Availability bias is about selecting investments based on how easily their memories are retrieved. In other words, full due-diligence should be ensured at every step so as not to miss-out on interesting opportunities.
Emotional biases on the other hand are purely psychological and do not stem from poor judgement, that is, they cannot be fixed with better training or advising. They are more difficult to correct.
Loss aversion is by far the most common emotional bias that exists and it is the act of cutting gains too soon and losses too late out of fear of missing out. The best way to remedy this is to stick to a fixed risk-reward ratio and to automate the position-closing mechanism.
Overconfidence means holding concentrated positions and results in trading excessively. A good streak does not mean that it will always be the case and thus, the trader must always follow procedures and ensure he does not stray from the strategy.
Self-control bias refers to a lack of discipline to balance short-term gratification with long-term goals.
Regret-aversion refers to staying in low-risk investment out of fear. This really is all about the risk profile of the trader. There is no right or wrong answer here but the fear of regret can make the trader lose out on interesting opportunities. One should take risks to make money.
Traditional finance assumes utility theory which asserts individuals have a limited budget and will select the mix of goods and services that maximizes utility, in other words, the indifference curve is convex. Behavioral finance presents four models for the markets:
1. Consumption and savings: traditional finance assumes investors are able to save and invest in the early stages of life while behavioral finance’s consumption and savings approach proposes an alternative behavioral life cycle model that questions the ability to self-control and suggests individuals show mental accounting and framing.
2. Behavioral asset pricing: traditional finance assumes market prices are determined through an unbiased analysis of risk and return. The behavioral asset pricing model adds a sentiment premium to the discount rate, it can be estimated by considering the dispersion of analysts’ forecasts.
3. Behavioral portfolio theory: rather than a well-diversified portfolio prescribed by traditional finance, individuals will construct a portfolio by layers. Concentration is nearly risk-free or high risk. The result is suboptimal because the construction did not take into account correlations.
4. Adaptive market hypothesis: assumes successful market participants apply heuristics until they no longer work and then adjust them. It assumes that no strategy should work all the time, survivors change and adapt, and active management can find opportunities.
The value of an item is determined based not on its price but rather on the utility it yields. Other issues that investors face in asset allocation is the well-known naïve diversification which is dividing assets equally among available funds irrespective of the underlying composition of the funds.
As a final point, all we have said can lead to a type of research called technical analysis which seeks to exploit these behavioral inefficiencies to predict market direction. Technical analysis relies on indicators and methods that quantify some psychological patterns we see everyday. One such example is the apparition of a doji candlestick. The doji is where the opening price equals the closing price signalling that the weak party of a prevailing trend is begining to regain control. Think of a bullish trend with smaller candlesticks (smaller difference between the closing and opening prices) until the point they are equal.