Behavioural Finance is a relatively new field of study which proposes a psychology-based approach in understanding market anomalies. There are several major behavioural biases that affect us as market players – stock/portfolio analysts, portfolio managers, advisors and end investor clients. We will therefore be exploring several of these biases in aim to provide a better understanding, as a basis for managing this form of risk - currently unaccounted for in classical financial and investment models.
Also known as the Conformity Bias - refers to the propensity for individuals to mimic the actions of others in a scenario, rather than use their own judgment. Following the majority feels less risky than being in a position on one’s own, particularly during volatile market conditions.
Herd Bias refers to the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. Social pressure of conformity, how can everyone be wrong?
Example – During the Dot Com Era venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models.
Loss Aversion refers to the propensity for individuals to strongly prefer loss avoidance to acquiring gains. Individuals tend to value gains and losses of the same degree differently, and are therefore more likely to pay a higher price to keep something than initially paid in acquiring said something.
Loss aversion refers to the tendency for individuals to strongly prefer avoiding losses over acquiring gains. Some studies suggest that losses are twice as powerful psychologically, as gains. One who loses $100 will lose more satisfaction than another person will gain from a $100 windfall.
Recent example: half of a room full of 50 CIO’s acknowledged that someone on their senior staff was not a good fit for the team, but was unwilling to take action.)
Endowment Effect deals with sentiment. Having to let go of something one once had is not as easy as foregoing up something one never had. Think of the return policy of many shops.
“How much value would you place on an ornament passed down from your great-grandmother? You would most likely consider it priceless, while the next person might only consider it worth a few dollars – if anything.”
This is known as the Endowment Effect. This bias results in individuals attributing a higher value to things, simply because it belongs to them. Your old pair of torn jeans may appear valuable in your eyes, but worthless in the eyes of another. That is because you have grown ‘attached’. Now think in terms of an investment; do you really believe that investment is worth as much as you say, or is it simply because you are already invested in it?
The Endowment Effect has the tendency to distort value of things. The value of goods, stocks and investments suddenly become subjective. This is why we have discrepancies in market Bid and Ask prices. It is no coincidence that Ask prices tend to be higher than Bid prices; individuals in possession of a stock/investment attribute a higher value to it due to the Endowment Effect. It is the one of the reasons markets are inefficient - everyone is quoting a different price on the same instrument due to their differing personal attachments with said instrument.