What about Behavioral Finance?
A Rational Decision in an Irrational Market

In this article, I am attempting to conclude some of my thoughts on the role of behavioral finance in the near future. But before I go on to talk about behavioral finance, allow me to point out some of the possible weaknesses of 2 of the most well researched areas, basically, Technically Analysis (TA) and Fundamental Analysis (FA).

For TA, it is a study of past data and trends to predict the future trends and price movements. Yes. Studying past data and trends may be useful for investors to study the trailing behaviors and trends of the market. However, does looking at the past say anything about the future? Although I cannot deny that there are people making profits based on technical analysis, past trends may still not be truly reflective of future trends.

For FA, it is a study of financial statements and ratios of the company, industry and the market. No doubt that fundamental analysis may be useful in analyzing the current financial health via financial ratios and through these analysis, investors may be able to predict the future direction of the investment. I cannot deny that fundamental analysis is useful since investors such as Warren Buffett has made it rich using fundamental analysis. However, there are some anomalies that cannot be explained by financial ratios or models such as CAPM (Capital Asset Pricing Models). In other words, using fundamental analysis in an attempt to find the true “intrinsic” value sometimes does not reflect the actual market price.

Given the limitations of TA and FA, what can investors do to get a more wholesome picture of the investment and the market?

Perhaps Behavioral Finance may be the answer.

So what is Behavioral Finance?

“Behavioral Economics and Behavioral Finance are closely related fields making up a separate branch of economic and financial analysis using social, cognitive and emotional factors to understand the economic decisions of consumers, borrowers and investors, and their effects on market prices, returns and the allocation of resources.” (Wikepedia)

In short, behavioral finance is the study of investors’ characteristics. I shall touch on some aspects of behavioral finance mainly “emotions” and “herding” to illustrate my point how behavioral finance could be useful for investors.

Emotions

“Emotions are an essential part of decision making because emotion is the necessary trigger to an action state. Individuals who are without emotion tend to make poor decisions, if they can be said to make decisions at all.” (Robert A. Olsen, 2008)

“Path-breaking work by Damasio (1994) indicates that a lack of emotion has striking effects on decision making. Damasio offers behavioral and physiological evidence in support of the hypothesis that decision making is intertwined with emotion. He studied brain-damaged patients who had impaired emotional responses even though they retained their cognitive abilities. The patients were emotionally flat as a result of frontal brain lobe damage, yet their knowledge, attention, memory, language, and abstract problem solving were unaffected. These individuals had difficulty making decisions and were unable to plan for the future or choose a course of action. Damasio hypothesizes a connection between flawed reason and impaired feelings.” (Lucy F. Ackert, Bryan K. Church, and Richard Deaves, 2003)

From the above studies, emotions are said to be essential in making decisions. For example, if you buy a stock, other than your own analysis on the stock, your emotions also influence your decision. Basically, you feel good about the stock so you buy the stock. On the contrary, you sell the stock because you feel bad about the stock or you feel that it is time to sell to gain the profit. Thus, there is no way an investor can make a decision without any emotions. So, perhaps the aggregate emotions of people in the market do have some influence on the future stock price movements.

Herding

“Herding refers to the situation where forecasters or investors tend to “shade” their forecasts or investment decisions in the direction of a reference group. The reference group may be colleagues or other market participants.” (Robert A. Olsen, 2008)

This means that if a group of people is heading to one direction, the others will tend to follow the crowd. Humans tend to see that the larger the group, the lower the risk. This is like the basic herd mentality especially in times of uncertainty. Let me illustrate the herding effect with the following example.

 

Let’s say that there are only 10 investors in the market. All investors A to J enter the market at different timings from T to T+9. Let us analyze the investors’ decision.

All investors A, B, C, D and E make a buy decision. This is what I call the herding effect, whereby, investor B follows investor A, investor C follows investor A and B, investor D follows investor A, B and C, and investor E follows investor A, B, C and D. With respect to the real market, herding is common especially during times of uncertainty, where one investor tend to follow the crowd and the tendency to follow the crowd becomes greater when the crowd gets bigger and bigger. It is something like peer pressure. As a result, the stock price rises because of the investors’ herding actions and all of them stand to gain from buying the stock.

For investor F however, he chooses to sell instead of following the crowd. Other investors, namely investor G, H, I and J follow the majority of the crowd (investor A, B, C, D and E) and buy the stock. As a result, the stock price is pushed up even higher and investor F stands to lose because he chose not to follow the crowd. This illustrates the point that even if the market is irrational at times, sometimes, it is rational (sensible) to follow the irrational market.

In conclusion, perhaps, human emotions and reactions to the market are reflected in the future stock prices. Thus, rather than just following TA and FA, investors should also pay attention to the investors’ behavioral in the market. In other words, sense the market. To be frank, not everyone has the ability to sense the market and it is not that easy to sense the market. Nonetheless, why not observe the price movements and the market for maybe a few days or even weeks so as to try to decipher the aggregate market emotions and get a sense of where the market is heading to? I am not trying to say we must be investor A or investor B to lead the crowd, but rather being investor C or investor D (crowd followers) will be good enough. I believe behavioral finance still has a long way to go in terms of research and finding more concrete evidence to back up investors’ behaviors but I can foresee that as the financial markets develop and as the investing population grows, behavioral finance will have its growing importance. If you can’t beat the market, follow the market!