Behavioral investing # 1: Overview: Heuristics

Well, ‘Behavioral Investing’ may sound like a fancy term but it is as old as the existence of behavioral aspects influencing investment decision making.Talking about behavioral influences on us, few of my favorites quotes catches the essence like no other;

"If you don't know who you are the stock market is an expensive place to find out."

                                                                                                -George Goodman

"The markets are moved by animal spirits, and not by reason." 

                                                                                                         -John Maynard Keynes

“Markets can stay irrational longer than you can stay solvent.” 

                                                                                                         -John Maynard Keynes

 Behavioral investing is specifically focused on the study of the influence of various behavioral aspects on investment decision making in financial markets. Investment decisions are made by individuals as well as by entities. Knowingly and unknowingly, willingly and unwillingly – we are for most of our investment decisions (also for any other decisions!) under the influence of behavioral aspects. Like it or not, as long as humans are involved in investment decision making – one hundred percent rational unbiased decisions are a myth! Investment decisions such as buy, sell and hold in financial markets are influenced by two categories of biases namely; 1. Cognitive errors (biases) 2. Emotional biases. In many cases, heuristics are considered to be a source of such biases. Hence, let us understand heuristics first.

Heuristics – A mental shortcut / Rule of Thumb:

Origin: from Greek ‘heuriskein’ for ‘to find’.

“When we do not have the ability or willingness to process complex questions or have to choose out of multiple choices many times, we resort to a quick way of decision making based on what we already know”- that is 'heuristics’. It is a quick way or approach that the brain adopts to reach to the solution/conclusion. Many times heuristics are gained by trial and error method. Heuristics give us fast answers in order to make a decision pertaining to complex questions without involving yourself in exhaustive research and analysis. Though in a day to day life routine decisions taken based on heuristics are mostly prudent but It is important to note that not all such decisions taken based on the heuristics may turn out to be the optimal/best choice. Hence, these decisions are prone to error. 

We daily apply heuristics, period. But why? Well, we have increasingly come to know that our brain cannot process way to complex things and also our system 2 (as described in the book: ‘Thinking fast and slow’) is lazy processing complex set-ups as processing complex set-ups consumes a significant amount of energy. Hence, naturally and sometimes after training our brain starts developing a mental short cut to process or perform tasks. 

Example from daily life:

1.  How many times you have bought the product just because it was ‘limited edition’ product or having only a few units left? When our decision to buy a product is majorly driven by scarcity of the product rather than requirement/utility/feature of the product – we are affected by ‘scarcity heuristic’. 

Example from investment world:

1. The rule of 72 is heuristic. All it provides is the quick but not precise answer to the question of how many years it will take to double my money at a given interest rate.

2. Asset managers, investors and financial professionals apply heuristics to speed up the investment decisions based on limited data set. ‘Copycat investing’ can be termed as heuristics, where an investor is trying to follow blinding other famous investors’ strategies.

One of the very famous heuristics which distort investment decision making is ‘representativeness’.

Representativeness Heuristic:

Investors can be under a heavy dose of representative bias when they make long-term investment decisions based on recent (last few quarters or last few years) performance of the mutual funds/stocks etc.This bias also hit us hard when we choose a particular broker or a stock analyst because of his stellar performance in the last few quarters. In this context, when a very small sample time frame is taken for the analysis purpose and labeling (hot or not so hot!) of a particular mutual fund/ stock/broker/ analyst is done based on performance during that time frame -we are likely to make faulty long-term investment decisions.

Applying heuristics have advantages as well as disadvantages.The art is to know where not to apply heuristics!

Cognitive errors (Biases) and emotional biases will be up for a brief discussion in the next blog.

Behavioral Finance: Laying the foundation

Is it true that the pain from losses is more impactful than the happiness from the gain?

Why we keep on riding our loss-making investments?

Why we are more inclined to spend windfall (unexpected) gain for leisure but not so much with our ‘hard-earned’ money?  

Why we are more convinced to invest in the stock whose brand or company name is familiar to us even without having any idea about the financial health of that stock?

We are puzzled by questions like above and many more, which we shall try to elaborate and resolve in upcoming series of blogs on behavioral investing.  

My keen interest in behavioral finance (in general) and in behavioral investing (in specific) is instrumental in jotting down what comes next as a series of blogs in ‘behavioral investing’. But, before we jump to behavioral investing it is crucial to lay the foundation of behavioral finance and how it is positioned against standard (modern) finance. Hence, we go for a brief overview in this blog.

_______________________________________________________________

Standard (Modern) Finance: Rational ‘economic man’ (Homo economicus) and Rational markets: Homo economicus is rooted in neoclassical economics exemplifying ideal human economic behavior grounded on principles of 1) perfect information 2) perfect self-interest and 3) perfect rationality. Modern finance is built on the tenet of prefect rational behavior of agents and markets. Below Figure-1 establishes the fundamental idea and key contributors in standard Finance and behavioral finance.

Figure-1: Standard Finance V/S Behavioral Finance

Behavioral Finance: Since the 1950s, the confluence of experimental economics, cognitive psychology and decision theory started laying the foundation for the genesis of a discipline called ‘Behavioral Finance’. At the core of behavioral finance is the premise that agents (humans) do not behave completely rationally all of the time while making financial decisions. Behavioral finance believes that financial decision making is influenced by the behavior of decision-maker which in turn is influenced by biases and heuristics. Here, the focus is on how individuals and markets behave in reality rather than in theory. Behavioral finance branches out into two categories;

1.Behavioral Finance –Micro aspects (Individuals/Investors):

Theory of Moral Sentiments (1759) by Adam Smith was perhaps the first account that focused on the emotional and mental underpinning of human interaction in economic activity. Likewise, Jeremy Bentham also elaborated on the psychological aspects of economic utility. These early thinkers recognized the role of psychological idiosyncrasies in economic behavior. But the voice of these early thinkers lost amid the rise of revolutionary neoclassical framework around 1870. At the heart was ‘Rational Economic Man’. Rational economic man epitomizes the idea of maximizing economic well being and expected utility, utility-optimizing goals and using all the information available to take the most rational decision. The famous economist John Maynard Keynes was never a proponent of ‘Homo economicus’. He believed in animal spirit – human emotions that played a role in many actions. A much better version of this philosophy was bounded rationality of Hebert Simon.  Bounded rationality assumes the choices of individuals may reflect rationality but there is a limit to the knowledge and cognitive capacity. Behavioral finance disputes the idea of rational economic man which is a key tenet of standard finance.

2.Behavioral Finance –Macro aspects (Corporates, markets and economies):

Behavioral corporate finance: It is a study of financial decisions by principals (Promoters) and agents (CEO,CFO, managers etc.) in a corporate setting with the understanding that decision-makers are less than fully rational and influenced by biases and heuristics.

Financial Markets & anomalies: As opposed to the ideology of standard finance/economics that markets are rational and efficient, behavioral finance argues (based on evidence) that markets have a tendency of over-reacting and under-reacting and markets are prone to behavioral effects. Thousands of studies have emerged out of never ending ‘market efficiency’ debate. Many studies have focused on existence and persistence of anomalies which are broadly categorized into three types as under;

 

Economics/ public policy-making: The policy-making is possibly least influenced but the most promising domain by behavioral economics. Here, the idea is to use behavioral insights to design and implement policy decisions with the aim of maximum reach and impact. Insightful paper by Raj Chetty, deliberates on how new policy tools can be created and how effect of existing policies can be improved with a behavioral economics approach. The idea of ‘Nudge’ by appropriate use of choice architecture as proposed in the book Nudge has gathered enough steam. Likewise, The Behavioral Insight Team which now has developed into the advisory unit assisting across policies, countries, NGOs on incorporating behavioral science insights for better outcomes.

Behavioral finance is an endeavor to understand and correct if possible (especially when we are biased/blinded) the very behavior of humans while making financial decisions.