"Recently we worked on a project that involved users rating their experience with a computer. When we had the computer the users had worked with ask for an evaluation of its performance, the responses tended to be positive. But when we had a second computer ask the same people to evaluate their encounters with the first machine, the people were significantly more critical. Their reluctance to criticize the first computer 'face to face' suggested they didn't want to hurt its feelings, even though they knew it was only a machine."
Bill Gates in The Road Ahead
"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."
Robert G. Hagstrom, The Warren Buffett Way
Most financial theory is based on the idea that everyone takes careful account of all available information before making investment decisions. It is assumed that human beings are rational. Behavioral finance -- which examines how people's emotions, biases, and misjudgments affect their investment decisions -- is one of the less discussed and understood areas of investing. Yet, this is perhaps what impacts markets the most.
Researchers in behavioral finance have come up with some interesting theories, which are briefly presented below:
Prospect theory - People respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain. They become considerably more distressed at the prospect of losses than they are made happy by equivalent gains. This 'loss aversion' means that people are willing to take more risks to avoid losses than to realize gains. Even when faced with sure gain, most investors are risk-averse, but faced with sure loss, they become risk-takers. According to the related 'endowment effect', people set a higher price on something they own than they would be prepared to pay to acquire it. Tversky and Kahneman originally described "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain.
Regret theory – This theory is about people's emotional reaction to having made an error of judgment, whether buying a stock that has gone down or not buying one they considered and which has subsequently gone up. Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a bad investment and the embarrassment of reporting the loss. They may also find it easier to follow the crowd and buy a popular stock: if it subsequently goes down, it can be rationalized as everyone else owned it. Going against conventional wisdom is harder since it raises the possibility of feeling regret if decisions prove incorrect. Professor Statman is an expert in the behavior known as the "fear of regret." People tend to feel sorrow and grief after having made an error in judgement. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. Many money managers and advisors also favor well known and popular companies because they are less likely to be fired if they underperform.
Anchoring - Anchoring is a phenomenon in which, in the absence of better information, investors assume current prices are about right. In a bull market, for example, each new high is 'anchored' by its closeness to the last record, and more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long-run averages and probabilities
Over- and under-reaction - People show overconfidence. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. And in certain circumstances, this can lead to extreme events
People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Researchers found that at the peak of the Japanese market, 14% of Japanese investors expected a crash, but after it did crash, 32% expected a crash. Many investment experts believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.
People often see order where it does not exist and interpret accidental success to be the result of skill. Tversky is well known for having demonstrated statistically that many occurrences are the result of luck and odds. One of the most cited examples is “Tversky and Thomas Gilovich's” proof that a basketball player with a "hot hand" was no more likely to make his next shot than at any other time. Many people have a hard time accepting some facts despite mathematical proof.
Two psychological theories underpin these views of investor behavior. The first is what Daniel Kahneman and Amos Tversky (co-authors of prospect theory) call the 'representativeness heuristic' - where people tend to see patterns in random sequences, for example, in financial data. The second, 'conservatism', is where people chase what they see as a trend but remain slow to change their opinions in the face of new evidence that runs counter to their current view of the world.
The bad news is that you cannot escape these patterns by giving your money to an expert to manage. The ideas of behavioral finance apply as much to financial analysts as they do to individual investors. For example, research indicates that professional analysts are remarkably bad at forecasting the earnings growth of individual companies. Evidence suggests that forecasts for a particular company can be made more accurately by ignoring analysts' forecasts and forecasting earnings growth at the same rate as the average company. The underlying reasons for the abject failure of the professionals are classic behavioral finance: they like to stay close to the crowd; and their forecasts tend to extrapolate from recent past performance, which is very often a poor guide to the future.
