The History and The Real Impact of Behavioural Finance 

People are complex and our financial institutions are designed for real people.

This study of behavioural finance started because of the revolution of neuroscience and the fact that the human brain is a complicated thing.

Very often people behave stupidly because we are humans and we have limits. We are aware of people’s behaviour and we have the impulse to exploit them.

Adam Smith is probably the most important figure in the history of economic thought. In 1759, he wrote his theory of moral sentiments.

In 1776, he wrote the most famous book on the wealth of nation which is considered the first real classic economic book. It stated that people inherently love praise and the approval of other people.

However, more matured people only love praise only when they feel they are worthy of it.

The book talked about a few psychology theory that affects how people behave in the financial markets.

1. Prospect theory is a theory of how people forms decisions on uncertainty. There is a value function on how people value things and weighting function on how people deal with uncertainty.It says that People estimate gains and losses from the reference point which is subjective and subject to manipulation. People are more affected by small losses and less encouraged by small gains. This kind of thing allows business to exploit people. In investment, people estimate gains and losses from the price the bought the stock at and are always more affected when their stock price go down as compared to when their stock price go up by a bit.We can tell someone the probability of some things, but we may not be able to take it psychologically. For very low probability, people may round them to zero, for high probability, people may round them to 1. If we cannot decide to round them to zero or one, we may exaggerate it to extreme. If we think 1 in 10 million airplane flight crashes we may round it to 0. If we think there is a higher possibility, we may exaggerate it out of proportion and if we think it is highly likely, we will just treat it as a confirmed thing. This lead to irrational selling of stocks in the stock market when people are unclear of the probability of how bad the impact of certain things could be.
2. Regret Theory is people’s fear of the pain of regret. You may make bad decisions because you overly worry about regret. We may not want to sell off our stocks even if that is the correct thing to do because we may be afraid that we would regret it.
3. Overconfidence theory found that there is a human tendency to overestimate their ability. Most of us think we are above average. The world is infinitely complicated. This is a problem because if we are too confident of our investment idea and got complacent, we might be missing out on other key things that we do not know about.
4. Cognitive dissonance is a judgemental biased people tend to make because they don’t want to admit they are wrong. We tend to cling on to old investment belief and find evidence that supports our beliefs. We have an exaggerated impression and forget the evidence that is contrary to our thesis and only finds the one that supports our investment theory.
5. Social psychology says that people are interdependent which is also known as herd behaviour. This does not happen consciously. Our opinion of what is happening is formed as a collective sharing of information. Herd behaviour creates big swings in the stock market. The key is here is that herd behaviour does not happen consciously, that is why we need to be extra aware of where do our beliefs about certain things come from. We have to make sure we try our best to think independently and not follow the crowd. That is why Warren Buffett says “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

David Swensen who managed Yale portfolio for a few decades says that in financial market it all depends on:

1. What assets you want in your portfolio
2. Asset allocation percentages
3. Make a market timing decision
   -Short term vs Long Term
   -Security selection, for example, buying the market or index fund so your return on security selection is zero. Security selection is to beat the market and your bets or series of bets determines it whether you can or not.
   -It is a zero sum game for security selection. The amount by which the winner wins is the amount which loser loses. Or negative sum game which the negative is the commissions paid to the broker.

In a panic only two things matter:

1. Risk
2. Safety

Under risk, people will fly to safety.

Diversification makes an enormous amount of sense in the long run.

Individual pursuit of their own advantage is what makes the economy go.

In investment, never forget to take note of whether the management interest is aligned with the company and the shareholder’s interest.

If their individual pursuit is not aligned with the company’s and the shareholder’s, the stock price will suffer.

Sign up for my premium investing newsletter

Further Reading: