Behavioural finance
I have no doubt that psychology plays a huge part in determining market prices. Fear and greed drive prices away from their intrinsic values. However, while it is interesting to understand how investors behave in different circumstances and why they behave that way, behavioural finance cannot be used directly to make money. Nevertheless, an understanding of behavioural finance helps to avoid some irrational decisions.
Some of the findings of behavioural finance are:
Investors under-react to new information. Their prejudices prevent them from changing their minds quickly. That contributes to a delay between new information becoming available and the price adjusting to the full extent.Growth shares are more susceptible to fear and greed than value shares.
Investors generally are not comfortable behaving differently from the majority though general moods of pessimism and optimism cause prices to be under or over their intrinsic values.
Investors tend to rationalise chance events and assume that these could have been predicted with foresight.
Investors use simple rules that may have worked in the past but do not recognise when conditions have changed that make these rules invalid.
Investors tend to extrapolate from historical data and assume that the trend will continue.
Investors are influenced by whatever they paid for the share and are reluctant to take losses though the conditions may have changed.
Investors sometimes gather a lot of irrelevant information and then get the mistaken belief that they have researched the company thoroughly. They are unable to discern the crucial bits that will drive the price.
Investors tend to sell winners too quickly to hasten the feeling of pride at having bought a winner and sell losers too slowly to avoid as long as possible the feeling of regret at having bought a loser.
Investors focus on the available information and do not think sufficiently about the risks of not considering the unavailable information.
Investors tend to overweight recent information and underweight long-term tendencies.
Investors focus on information that confirms their belief and underestimate the significance of information that is contrary to their belief.
Investors down play the possibility of unknown unknowns.
Investors think that they are smarter than they really are.
Investors pay too much attention to new or easily remembered information.
Investors have loss aversion, i.e. tendency to feel the pain of losing money much more intensely as the enjoyment of making it. This results in investors being too cautious and investing less in risky assets that would give long term returns.
Investors have confirmation bias, i.e. they seek out information that supports their prejudices.
Investors have the endowment effect, i.e. they ascribe a higher value to what they own than to what they do not.
Investors suffer from anchoring, i.e. they give illogical weight to the price at which they bought a share.
Investors have herding bias, i.e. they are influenced by a consensus of other people’s opinions, even if they are ill informed.
Investors have status quo bias, i.e. they are reluctant to change their belief that the shares that they own are better investments than shares that they do not own.
Investors gravitate towards their domestic market, rather than diversify globally - home bias.