The Functional Brain
Behavioural Finance incorporates elements of cognitive psychology, economics and sociology to explain why investors depart from full rationality and therefore why markets depart from full efficiency. Cognitive Psychology is concerned with how we process information, draw conclusions and make decisions. It studies the mental processes by which sensory input is transformed, reduced, elaborated, stored and recovered. By considering the impact of emotions, cognitive errors, irrational preferences and the dynamics of group behaviour, behavioural finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.
Behavioural Finance does not assume that all investors are irrational. Rather it views the market as a mixture of decision makers who vary in their degree of rationality. When irrational investors (noise traders) trade with rational investors (arbitrageurs), markets can “depart from efficient pricing”. Behavioural Finance rests on two foundational pillars: The “limited ability of arbitrage” to correct pricing errors and the “limits of human rationality”. When both notions are combined, behavioural finance is able to predict “specific departures from market efficiency that produce systemic price movements”.
In contrast to traditional finance theory, behavioural finance asserts investors make biased judgments and choices. In effect market prices systemically deviate from rational values because “investors systemically deviate from full rationality”. However these mistakes are not a sign of ignorance, but rather a consequence of the generally effective ways human intelligence has developed to cope with complexity and uncertainty. Behavioural finance argues that some departures are systemic and last long enough to be exploited by certain investment strategies.
Building a Blueprint for Your Investments
Neuroscientists have recently uncovered two particular traits of significance to investors. The first is that we are “hard-wired for the short term”. We tend to find the chance of short term gains very attractive. They appear to stimulate the emotional centers of the brain and release dopamine consequently making us feel confident, stimulated and generally good about ourselves. The second is that we appear to be “hard-wired to herd”. The pain of social exclusion i.e. betting against everyone else is felt in exactly the same parts of the brain that feel real physical pain. Our ability to use self-control to force our cognitive process to override our emotional reaction – the more we use it, the less we have left to deal with on the next occasion when self-control is required. With emotions we cannot control ourselves and without them we cannot make decisions. We appear to be doomed to chase short-term rewards and run with the herd. When we try to resist these temptations we suffer subsequent declines in our ability to exercise self-control.
However modern neuroeconomics reveals that the number of brain cells are not fixed and not decayed over time. We are capable of generating new brain cells over most of our lifetime. In addition the brain isn’t fixed into a certain format. We can remap and rearrange the pathways (neurons). This is how the brain learns and this process is properly called “Plasticity”. As such we are not doomed and we can learn albeit not easy!
There is persuasive experimental evidence that human minds are essentially not optimized for investment decisions. There is empirical ground that we are all likely to suffer from what psychologists call “Heuristics” and “Biases”. Heuristics are just rules of thumb that allow us to deal with informational deluge which at times work well but can lead us far stray from rational decision-making. We would all like to think that we are immune to the influence of behavioural biases but statistics however demonstrate that all humans are likely to suffer some mental errors on some occasions.
Most of these mistakes can be traced down to four common causes: Self-Deception; Heuristic Simplification; Emotion and Social Interaction.
The appended figure outlines the most common of the various biases that has been found and highlights those with “direct implications for investment”.
A Taxonomy Of Biases
Self Description(Limits to Learning)
- Overoptimism (Illusion of Control) (Illusion of Knowledge)
- Self Attribution Bias
- Confirmation Bias
- Hindsight Bias
- Cognitive Dissonance
- Conservatism Bias
Heuristic Simplication(Information Processing Errors)
- Loss Aversion/Prospect Theory
- Self Control(Hyperbolic discounting)
- Ambiguity Aversion
- Regret Theory
These are the most common “mental pitfalls” that investors stumble into.
To avoid plunging headlong into them an investor must have an investment process that incorporates “best mental practices” which require you to step back from the day-to-day “market turbulence” and comprehend how to apply psychology’s findings to your own behaviour.
The appended rules could substantially mitigate the effects of stated biases:
- Try to focus on the facts and not the stories.
- More information doesn’t equal better information.
- Don’t overweight personal experience.
- Failure cannot be attributed to bad luck alone. Examine mistakes to improve your performance.
- Don’t value something more, simply because you own it.
- Don’t take information at face value. Think carefully about how it was presented to you.
- You know less than you think you do.
- Look for information that disagrees with you.
- Think whether a piece of information is high strength and low weight, or low strength and high weight.
- Big, vivid, easy to recall events are less likely than you think they are.
- Set up sensible valuation framework. Replace the unimportant with the relevant.
- Judge things by how statistically likely they are, not how they appear.
- Sell your losers and ride your winners.
Uncertainty of Foresight
Identifying the psychological flaws in the “average” investment process is an important step in trying to design a superior version that might just be more robust to behavioural biases. It is important that your own individual objectivity is always maintained as groups are far more a behavioural panacea which can be counter-productive by amplifying rather than alleviating the problems of decision-making. A successful market operator must isolate himself to control the debilitating psychological effects of outside influences because they can easily divert the unwary from executing an otherwise perfectly conceived plan of action.
Even the most astute, highly motivated, well-grounded traders can be crippled by counterproductive thinking that leads to poor decisions and trading errors. They suffer from an inability to stay objectively focused or lack the necessary confidence to execute their trades properly. Or they let deeply ingrained mental contradictions and misconceptions about trading of the nature of the market rule the stock-picking.
A “Winning Mindset” perhaps is the most essential aspect of the investment and trading process!