Does the stock market have human tendencies? If not then why does it behave similarly to a human prone to cognitive biases?
Is it weird to think of the stock market having human tendencies? Is it all that lifeless? If so, then why does the stock market crash as if it’s having angry fits and then recover in a feeling of euphoria? Since the time we can recall, we’ve assumed humans to be rational investors. This is taught to us as one of the many assumptions of any economic theory that we’ve studied in school. But humans, just like any other species, aren’t completely rational and the decisions are almost always influenced by some bias. Keeping this in mind, do the ‘moods’ of the market seem all that strange? Can we even predict or comprehend these market sentiments?
This is where behavioural finance comes in. To define it in layman terms, as the name suggests, behavioural finance is the study of the influence of psychology on the behaviour of investors or financial analysts. Behavioural finance treats investors as “normal” as opposed to “rational”: taking into account the fact that humans have limits to their self-control and can make cognitive errors that can lead to incorrigible mistakes.
It suggests theories based on human psychology in order to explain the concept of stock market anomalies, which includes extreme rise and fall in the prices of stocks (for e.g. the Dot-Com Crash), making the Efficient Market Hypothesis (EMH) a hard pill to swallow. Thus, implying that the structure of the information and characteristics of participants of the market play an important role in decision making of the investors as well as the overall outcome of the market.
There is no doubt that, since the onset of the coronavirus, the markets have reacted rather dramatically. The “VIX” Index, also referred to as the fear or volatility index, measures, and is directly correlated to, the volatility of the market, hit a record level of 80, exceeding its peak during the 2008 financial crisis. So, during times of such tremendous fluctuations and emotions running at an all time high, how do we still try to conform to the standards of a “rational” human being, so to say? This is precisely where behavioural finance chimes in.
In his book, Daniel Kahneman (who along with Amos Tversky is considered one of the fathers of behavioural finance) drew a distinction between two large areas of the brain that have very different functions, pointing out that we cannot know which part of the brain is working at any given point in time.
Briefly expanding on the topic at hand, this is how our brain works – (Yes, I’m aware you didn’t come here to study human anatomy but believe me this is interesting stuff )
The limbic system: One part of the brain, the limbic system, is very fast, very emotional. This is where the so-called “gut feeling” originates. The neocortex: The other part of the brain, the neocortex, is slower and is in charge of our rational thinking, or careful reasoning. The brain stem: To be exact, we should also include the brain stem. Evolutionarily, it is the oldest part of our brain. This is where the fear center is located.
The structure of our brain follows evolutionary logic: In the early history of human evolution, those traits and skills that were required for survival were also the ones that developed first. Our ancestors needed to perceive risk and to flee from dangerous situations as quickly as possible. The need for logic arose much later. As a result, during a crisis, the fear center is the first to spring into action. When it detects danger, the limbic system takes over and reacts rapidly and instinctively. To do so, it relies on behavioural patterns to escape from the danger zone, without any conscious reasoning.
Keeping in mind whatever we have discussed, it is fairly obvious to conclude that anomalies and biases are bound to arise. Some of the common investor biases are –
Overconfidence bias: The human tendency to have too much confidence in our own abilities and skills is known as overconfidence bias. Following the 34% decline of the S&P 500 in March, some investors hoped they could accurately time the market. Accordingly, they preferred a strategy of cutting their equity exposure when the market was down and reinvesting once the markets had stabilized. However, while selling high and buying low makes logical sense, the reality is that it is very difficult to predict short term market movements particularly in highly volatile times and the market recovered almost all the losses in two months.
Herding bias: Many investors make the same decisions at the same time which causes contagion of thought, as well as rapid declines in asset values which cause them to become over/undervalued. Going against the herd can be extremely difficult, especially in a severe market decline, but for every seller there is a buyer. One could therefore argue that there are two herds moving in opposite directions and it is best to be following the herd that are buying bargains.
Confirmation Bias: Looking ahead to the outcome of the Covid-19 pandemic, there are currently two polar views – optimistic or pessimistic. Investors typically look for information that confirms their current belief – known as confirmation bias – and as a result they seek views that confirm what they already know, rather than looking for views that contradict theirs. As an investor, it is important to recognize whether you tend to have a glass half full or half empty view, because this itself is a behavioural bias. Instead of focusing on news that supports your view, you should remember that there are a range of possible outcomes.
Loss aversion: The best-known behavioural anomaly, whose discovery can be regarded as the birth of behavioural finance, is probably loss aversion. This refers to the fact that the pain we feel from one unit of loss is greater than the pleasure we derive from one unit of gain. In other words, we will be more upset over losing Rs. 100 than we will be thrilled about a Rs. 100 profit. Accordingly, we place greater weight on the current losses in the capital markets than on previous gains, some of which may have accrued over many years.
Tackling biases: To conclude all out insights from our newly gained knowledge, While even today it is important for us to rely on our intuition, it is just as important for us to understand and recognize these processes. But it is also important for us to think rationally in order to avoid overreacting. Self-awareness is the first step toward avoiding the wrong reactions. Outsmarting oneself is the second thing to avoid. Some strategies that investors should follow in order to minimize the effect of behavioural biases are as follows:
Aligning your portfolio with your goals The Odysseus Strategy is one of the best strategies to follow for investors to stay on track with regards to the goals they wish to achieve. Like the hero in the Greek epic, investors also need to commit to a strategy that will help them to stay on track.
Further, it is important to set up a robust financial plan and map it to an investment strategy using the 3L: Liquidity, Longevity, Legacy Framework.
The 3L framework helps you develop a personalized investment approach by segmenting your total wealth into three strategies: a Liquidity strategy, designed to meet your cash flow needs for the next two to five years; a Longevity strategy, consisting of the resources needed for spending throughout retirement and the rest of your lifetime; and a Legacy strategy that is earmarked for growth to benefit future generations and philanthropic organizations.
Understanding risk and your specific risk tolerance It is important for an individual investor to not let emotions reign free which eventually leads the investor to invest much more than the risk appetite. Thus, it is advised to carefully calculate your risk appetite and take the help of a financial advisor.
Diversify, Diversify, Diversify: Without diversification, an investment strategy has risk that is concentrated in one area, which means that it is fragile. Diversification works by introducing variety to dampen different types of risk. A diversified portfolio is composed of assets whose prices move out of sync with each other, such that extreme returns in one asset class are tempered by modest returns in other asset classes. The net effect of this interaction is a reduction in risk per unit of return, which means that diversification is therefore a very useful tool that can help investors achieve a greater potential rate of return while enjoying a smoother path of growth, and thus a more comfortable investment experience.
On a final note, humans are influenced by a wide range of cognitive biases and emotions that are amplified in adverse situations and lead to inconsistent decisions. The effects of the COVID-19 crisis on our collective psyche remain unknown, but history suggests it may leave a permanent mark on the way we save, spend, and invest — particularly among the young people who will come of age during the pandemic.
The stock price reactions suggest that broad actions, including fiscal policy interventions, are required to avoid further negative outcomes and propagations of the COVID-19 shock. The crystal ball of the market foretells a different economic landscape than the one we have gotten used to. Such changes bring potentially massive social and political upheavals. Hence, in order to implement appropriate public policies, governments should tackle this outbreak via a behavioural approach. The use of nudges during the gradual deconfinement is highly recommended because governments need to prepare the external environment for more social interaction, in order to prevent a second cycle of COVID-19.
Here’s hoping we can avoid the inherent dangers and benefit from the opportunities.