Behavioural finance and investment strategy

[Chapter Introduction and Objectives]: Many great minds, both academics and practitioners, have examined the financial markets in hopes of finding investment strategies that yield the nest results. And nearly all have based their theories on one assumption that investors always act in a manner that maximizes their returns. Yet volumes of research show that investors are not always so rational. Clearly, not every choice investors make is in their best interest. While emotions like fear and greed play a role in poor decisions, there are other causes of irrational behavior. Behavioral finance is the study of how these emotions and mental errors can cause stocks and bonds to be overvalued or undervalued. It has led to the creation of investment strategies that capitalize on this irrational behavior. This chapter has the following objectives: • Introduce the application of behavioral finance in constructing investment strategies • Describe the typical errors in investors’ information processing • Describe some of the commonly encountered behavioral biases of investors • Explain the limits to arbitrage • Reconcile market efficiency and behavioral finance In the chapters that preceded, we presented two broad approaches to security analysis. Fundamental analysis involves analysis of financial statements, strengths, and management quality of a firm and its competitors and markets. Technical analysis maintains that all information is reflected already in the stock price, so fundamental analysis is a waste of time. Technical analysis does not care what the intrinsic value of the stock is. Its price predictions are extrapolations from historical price patterns. A third branch called behavioral finance has emerged in the recent years as the third approach to investment analysis. It uses psychology to explain investor behavior that cannot be explained with traditional financial and economic theory. Traditional economic theory rests on the sensible assumption that investors make purely rational decisions. A rational decision, as defined by an economist, is one that maximizes an investor’s utility function. This simply means that when presented with a choice an investor will always choose the course of action that will gain the most for expending the least. Thus, it is a decision supported by logic and reason and is, therefore, deemed “rational” by economists. With this assumption made, economists were then free to develop mathematical models that now provide investors with the necessary tools to price assets, optimize portfolios, and quantify and manage risk – all valuable contributions and significant achievements. But was their underlying assumption correct? Do investors actually make purely analytical decisions devoid of emotion? Studies analyzing historical trades generated by both retail investors as well as professional traders reveal that, in fact, they do not. On the contrary, does this mean the pendulum swings completely the other way and the opposite is then true? Do investors make wild, unpredictable, or unexplainable decisions? No, this is not the case either. Behavioral finance, by utilizing the insights of psychology, provides the explanation. In the same way that the fields of macroeconomics and microeconomics simply reflect different scales or cosmoses of activity, man, or the individual investor, is a microcosmof the market as a whole. That is, the rationalization, psychology, and investing behavior of an individual investor is directly related to the thinking, feeling, and acting of all investors. The aggregate of all investors is, of course, the market itself. Thus, the best guide to how markets function is man himself. Indeed, human beings are the sole causal factors of the market. There is nothing in the market that is not a reflection of human behavior. The history of markets can even be seen as a complex set of recurrent human errors. We know the market habitually overreacts or underreacts. Behavioral finance provides an alternative explanation to some of the anomalies outlined in the chapter on market efficiency. It takes into account how real (different) people make decisions. Some of the irrationalities may arise because investors do not always process information correctly, and, hence, derive incorrect future distributions of returns. This results in arbitrage opportunities. Even while knowing the true distribution of returns, investors can make suboptimal decisions. Consequently, arbitrage is limited. Hence, the absence of arbitrage opportunities does not necessarily imply market efficiency. There are three different and distinct symptoms of the market which correspond to how participants feel (psychologicals), think (fundamentals), and act (technicals). By studying and measuring these three components, experts in behavioral finance arrive at a comprehensive analysis of the market. Each of these market functions are always in disequilibria to some degree. These persistent disequilibria result in systemic investing errors. Identifying the errors of other market participants, in turn, leads to investment opportunities. Some central issues in behavioral finance are why investors and managers (and also lenders and borrowers)make systematic errors. It shows how those errors affect prices and returns (creating market inefficiencies). It shows also what managers of firms or other institutions, as well as other financial players, might do to take advantage of market inefficiencies