Taming your emotions

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One of the great criticisms of much of economic and financial theory is that is does not take into account the irrationality and behavioural quirks of much human decision-making. At the same time, this is what makes the stockmarket such a fascinating place.

If we can guess how the broad mass of the market might react to a particular set of circumstances, we are halfway to making money.

Kahneman and Tversky

In the 1970s, two academics set about trying to make sense of all this in a rigorous way. Daniel Kahneman and his long-time collaborator Amos Tversky established a method to apply psychology to decision-making in finance and economics. This is the field of behavioural finance, still much discussed today.

Beginning with his post-war work for the Israeli army, Kahneman applied scientific research methods to biases in human behaviour brought about by imperfect knowledge or emotional quirks. He sought to understand economic and financial decision-making more clearly and to work out how it affected the establishment of, say, stockmarket prices, rates of return and the allocation of resources.

He received the Nobel Prize for Economics in 2002. In his acceptance speech he paid tribute to Amos Tversky, his long-time friend and collaborator - an Israeli who also became an American academic - who died in 1996.

But what exactly is behavioural finance and what techniques did this famous duo develop? Although Adam Smith and philosophers like Jeremy Bentham and John Stuart Mill had implicitly assigned some share of decision-making to psychological factors, most economic thought had assumed that decision-making was based on rational assessment of costs and benefits.

The possibility of decision-making being influenced by psychological factors had been part of the work of theorists like Pareto, Irving Fisher and Keynes, but not formalised or explored. In the 1960s, however, the rigid constraints of economic models were being challenged, not least because of the very obvious anomalies that these theories did not explain.

Human biases and 'prospect theory'

Among the anomalies were, for example: a bias in favour of the status quo, loss aversion, the gamblers' fallacy (the idea that the odds shift on a roulette wheel shift in favour of black after a series of reds), the money illusion, the downward stickiness of prices of large assets (for example, house prices) and a range of others.

Kahneman and Tversky used tests to benchmark behaviour against what economic theory suggested would be the result and codified the results in what has become known as 'prospect theory'. Prospect theory reckons that the way individuals frame an outcome or transaction in their minds before the event affects the perceived gain they expect or receive.

As far as the stockmarket is concerned, for example, it is clear that individuals act irrationally. They focus too much on the short-term. They are overconfident and place too much faith in their own ability even when facts show this to be unwise.

The big ideas in behavioural finance have emerged in a number of areas. One is that individuals often make decisions on the basis of illogical rules of thumb rather than by wholly rational analysis. A second is that the way a problem or a choice is presented to an individual can affect the decision.

Another point is that the spread of ideas and biases from individual to individual or the communication of the biases of a group of influential individuals - hedge fund managers, for example - can explain the herd-like behaviour that we know is capable of displaying.

Behavioural psychology explains a number of well-known phenomena in the stockmarket. These include an asymmetry in preferences between the acquisition and retention of resources. This is the 'bird in the hand' paradox. An individual would rather keep something they have acquired rather than part with it for a cash sum that exceeds its value. There is also aversion to selling at a loss and its converse - an over eagerness to take profits - which occur even though a rational assessment of the risks involved would suggest the opposite course of action is correct.

Rationality and long-termism

One crucial point made by Kahneman and Tversky is that people behave more rationally when they are thinking long-term than when they are focusing on immediate gains and losses.

Then there is the issue of overconfidence. Kahneman observed, for example, that "people assign much higher probability to the truth of their opinions than is warranted. It's one of the reasons people trade so much in the markets, generally with bad results. Another example is that people exaggerate their confidence in their trading plans. The existence of a plan tends to induce overconfidence.

"In many cases what looks like risk taking is not courage at all, it is just unrealistic optimism. Courage is a willingness to take a risk once you know the odds. Optimistic overconfidence means taking the risk because you don't know the odds. It's a big difference."

Peter says

I have always rather liked the idea of applying psychology to finance and one has to applaud the way in which these behavioural finance theorists have isolated and explained some of the puzzles about the way investors behave as they do and the way markets react.

There are plenty of critics of Kahneman and Tversky's ideas, not least from efficient market theorists. They say, for example, that behavioural finance is simply explaining temporary anomalies that would eventually be priced out of the market in the normal course of events or else that can be explained as persisting for a time at the individual level, but not generally true when applied to the market as a whole where individual biases cancel out.

There has also been some criticism of the reliance that the behavioural finance and behavioural economics theorists place on experimental and survey-based techniques used to arrive at the results and question whether stated preferences from surveys are actually consistent with the ways individual behave in reality, as revealed by the results of their decisions. Many economists distrust survey-based techniques for devising theories because of the ease with which systemic bias, strategic behaviour and other problems can be introduced into them.

Nonetheless, the fact remains that the stockmarket is self-evidently a place where emotions shift and hold sway over reason with varying degrees of intensity. Even if one does not accept their wider ranging conclusions, Kahneman and Tversky did many investors a service by pointing out the biases to which we are all subject and, in doing so, have at least given us the option to avoid acting on them.

Who knows, it could even lead some of us to make better, more profitable and more rational investment decisions?