Syllabus A. Role Of The Senior Financial Adviser A2. Financial strategy formulation

A2h. Behavioural Finance 9 / 9

Syllabus A2h)

Advise on the impact of behavioural finance on financial strategies / securities prices and why they may not follow the conventional financial theories.

Behavioural finance looks at why people make irrational decisions

Much of conventional finance is based on rational and logical theories, such as the CAPM and EMH

These theories assume that people, for the most part, behave rationally and predictably

But the real world is a very messy place people behave very unpredictably.

Contrary to convention we are not always "wealth maximisers".

Buying a lottery tickets is financially irrational for example.

Behavioral finance seeks to explain why we buy them

The "Anomalies" that behavioural finance seeks to explain:

  1. January Effect

    Average monthly return for small firms is consistently higher in January than any other month of the year. 

    Conversely, EMH suggests a "random walk"

  2. The Winner's Curse

    The winning bid in an auction often exceeds the intrinsic value of the item purchased - maybe due to increased bid aggressiveness as more bidders enter the market

  3. Equity Premium Puzzle

    CAPM says investors with riskier investments should get higher returns - but not so much!

    Shares historically return 10% and government (risk free) bonds 3% - yet shares are not over 3 times more risky - so why is the return premium so high?

    Behavioural finance shows people have a loss aversion tendency- so are more worried by losses in comparison to potential gains - so in fact a very short-term view on an investment. 

    So shareholders overreact to the downside changes. 

    Therefore, it is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss.

Key concepts of Behavioural Finance

  1. Anchoring

    We tend to "anchor" our thoughts to a reference point - especially in new situations 

    Large Coffee - £5
    Medium Coffee - £3.50
    Small Coffee - £3

    The large is the anchor - get you used to a price (with no logic behind it) thus now making the medium seem cheap. Especially as small (another anchor) is £3.

    A share falls in value from £80 to £30 - it now seems a bargain - but thats just not rational - you need to see the fundamentals of WHY the price fell not just look at the £80 anchor

  2. Mental Accounting

    Individuals assign different functions to each of their assets, often irrationally

    So a fund set aside for a vacation or a new home, while still carrying substantial credit card debt is crazy (if the debt is costing more than the deposit account)

    Some investors divide their investments between a safe and a speculative portfolio - all this work and money spent separating the portfolios, yet his net wealth will be no different than if he had held one larger portfolio.

  3. Confirmation Bias

    We all have a preconceived opinion. 

    So we selectively filter and pay more attention to information that supports our opinions, while ignoring the rest

    An investor "sees" information that supports her original idea and not the contradictory info

  4. Gambler's Fallacy

    You've flicked a coin 10 times - its always been heads amazingly. 

    Whats the chances of it being Tails on the next throw?

    A gambler MAY incorrectly use the past info to try and predict the future. This is crazy. The chance is still 50%

    Some investors sell after a share has risen many times in the recent past - surely it can't continue going up? Of course it can - the past has no effect on the future in these situations

  5. Herd Behaviour

    We mimic the actions (rational or irrational) of a larger group. 

    Why else would anyone choose BPP or Kaplan over us?? :)

    Individually, however, most people would not necessarily make the same choice.

    The common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very little experience.

    Think about investors in many companies in the past - all following each other when fundamentally the businesses were not strong

  6. Overconfidence

    74% of professional fund managers believe they deliver above-average job performance! :)

    Overconfident investors generally conduct more trades than their less-confident counterparts.

    Overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. 

    Unfortunately,  traders that conduct the most trades tended, on average, to receive significantly lower yields than the market.

  7. Overreaction Bias

    One consequence of having emotion in the stock market is the overreaction toward new information. 

    According to EMH semi strong markets, new information should more or less be reflected instantly in a security's price. 

    For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.

    Reality, however, tends to contradict this theory. 

    Often, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. 

    Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.