Navigating the waves of emotion: The mysteries of investor psychology
By Mohamed Touzi, Risk Manager
Key messages
This article explores the fascinating interface between behavioral finance and risk management. It highlights the crucial importance of integrating psychological and emotional aspects into financial decisions.
· Human emotions and irrational behavior influence financial markets, often to the detriment of objective financial data. In this context, the influence of emotions such as fear and greed on financial decisions reflects the subjective value function in action, where emotions and subjective beliefs affect the perception of risks and potential returns (the subjective value function).
· Vigilance and the questioning of beliefs are crucial in asset management, as even the most confident managers must be prepared to adjust their positions according to market developments (the Dunning-Kruger effect).
· Integrating behavioral perspectives into investment strategies is essential to developing more robust and adaptive approaches, enabling investors to better navigate a complex and uncertain financial environment (the fusion between behavioral finance and risk management).
This study is a reminder that, in an ever-changing financial world, an understanding of behavioral and emotional aspects is essential for successful anticipation, risk management and seizing opportunities.
Investment involvement
Financial management is based on a variety of methods, including passive, active and algorithmic management. In passive management, investors generally follow a benchmark index such as the S&P 500 and do not try to outperform the market. Active management, on the other hand, involves management decisions taken by financial professionals with the aim of outperforming the market. Algorithmic management, on the other hand, relies on the use of sophisticated computer algorithms to carry out trades according to pre-established conditions. Whatever the method used, however, it’s crucial to recognize that financial decisions are always influenced by human behavioral factors. For example, even in a context of algorithmic management, where decisions are often based on mathematical models, it may happen that a stock suffers a sudden drop, leading to a massive sell-off by investors, a phenomenon often observed in behavioral finance. Ultimately, this underlines the importance of understanding and taking into account behavioral aspects in all aspects of financial management, regardless of the management method used.
In this context, cohesion and organization between risk management and Richelieu Gestion’s portfolio managers are crucial to effectively integrating the principles of behavioral finance into financial decision-making. By identifying, assessing and managing financial risks, risk management plays an essential role in protecting the company’s assets and preserving its financial stability. Working in close collaboration with the portfolio managers, who are responsible for the active management of portfolios, risk management can draw on their knowledge and expertise to understand market behavioral trends and cognitive biases that can influence investment decisions, such as the discussions that can take place following specific events impacting the valuation of a position held. Together, they can develop more robust risk management strategies that take into account the psychological and emotional aspects of financial decisions. By integrating behavioral finance perspectives into their decision-making processes, risk managers and portfolio managers can better anticipate market reactions, mitigate the effects of cognitive and emotional biases, and optimize corporate financial performance over the long term.
Contents
1. What is behavioral finance?
Behind the scenes of the financial world, where the destinies of daring investors are charted, lies an elusive mystery that often eludes the untrained eye. A thick veil surrounds an emerging discipline, behavioral finance, forged in the crucible of the 2008 financial crisis and enriched by enlightened minds such as Daniel Kahneman and Richard Thaler, honored with the prestigious Nobel Prize in Economics.
In-depth studies conducted between 1990 and 2009 revealed that a considerable number of investors failed to outperform benchmark indices over the long term. The reason behind this gap between theory and practice lies intrinsically in the behavior of investors themselves.
Imagine a world where markets are not simply mechanisms of rational efficiency, but arenas where the whims of the human mind intermingle. This is where psychology meets finance, defying established conventions.
In this intriguing exploration, we lift the veil on behavioral biases, those subtle shadows that guide financial decisions, revealing a complex world where apparent rationality dissipates in the meanders of human nature. Hold on tight, because this journey will take us beyond appearances, to where the mysterious threads of behavioral finance are woven.
What is behavioral finance?
In essence, behavioral finance emerges at the intersection of psychology and finance, clearly demonstrating its divergence from classical financial theory. The latter, based on the assumption of individual rationality and market efficiency, is challenged by behavioral finance, which emphasizes the influence of emotions, cognitive biases and human behavior in the financial decision-making process. Despite its development, this field remains controversial as to its actual contribution to investor performance.
Cognitive biases
In the fascinating maze of our thoughts, cognitive biases reveal themselves as filters that subtly alter our decisions and evaluations. This journey explores the unconscious mechanisms that can mislead our discernment without our being aware of it. Representativeness, guided by the propensity to generalize our personal experiences, colors our professional judgments. In the financial field, “momentum” influences investment choices, while consensus assessment can be distorted by an egocentric tendency. Analogical reasoning, sometimes at odds with reality, deserves particular attention. Cognitive conservatism, the natural inclination to overvalue confirmatory information, hampers objectivity in decision-making. Confirmation bias, favoring data that conforms to preconceptions, can alter the quality of professional choices. Finally, the phenomenon of anchoring, illustrated by the association of seemingly disparate ideas, is revealed in the business world, through the influence of Daniel Kahneman.
· The Dunning-Kruger effect
Are we all susceptible to overestimating our abilities? The Dunning-Kruger effect, or “excessive self-confidence”, is a well-established principle that can be detrimental to the company and difficult to manage. This is the principle according to which incompetent people believe themselves to be competent, i.e. they overestimate their abilities and performance. In management terms, the Dunning-Kruger effect refers to those ineffectual employees who are nonetheless very sure of themselves.
Source : Hubspot
The person suffering from the Dunning-Kruger effect is not necessarily aware of his or her overconfidence. In short, an employee suffering from this syndrome thinks he has mastered a subject to perfection, when in fact he hasn’t, or has no qualifications whatsoever. They are so convinced of their own incompetence that it becomes difficult for them to realize it.
At the heart of the notion of market efficiency lies the fundamental assumption of investor rationality. This stipulates that all market participants are equal before information, thus inducing a natural propensity towards rationality. However, the gap between this theory and reality becomes apparent when investors’ decisions are significantly influenced by emotional factors.
Where theory expects constant rationality, practice reveals the predominance of emotions in the decision-making process. Fear, greed and other feelings can influence investors’ choices, introducing significant variations from assumed rationality (see chart below).
Source : Bertrand Dubourg
Financial psychology highlights a persistent reality : human beings react asymmetrically to losses and gains. When a banker shows his client a portfolio showing losses, the distress felt is far more intense than the satisfaction provided by equivalent gains. This emotional disparity, more specifically loss aversion, was described by Kahneman and Tversky in their “Prospect Theory” in 1979, earning Kahneman the Nobel Prize in Economics in 2002. Even if most positions in a portfolio show gains, investors tend to concentrate on positions that are declining. Prospect theory sheds light on this asymmetry, emphasizing that individuals are more sensitive to prospects of losses than of gains. The proposal of a new utility function, the value function, to which we’ll return later, bears witness to the complexity of investors’ psychological responses, combining risk-return aversion and risk-loss seeking.
This deeper understanding of the emotional interplay between losses and gains offers a crucial perspective for more informed and adaptive portfolio management. Furthermore, it has been observed that early gains generate significant satisfaction, while substantial gains are often undervalued. A notable trend in investor behavior is the propensity to take greater risks in the event of loss, a phenomenon similar to that of wanting to “remake” oneself at the casino. This inclination translates into a tendency to quickly sell profitable positions rather than liquidate losing ones, illustrating what is known in behavioral finance as the “disposition effect”. At the same time, risk aversion may lead an investor to sell a stock when it reaches an all-time low, rather than buy more.
Finally, the desire to minimize potential regret in the event of failure, or the fear of the unknown, is a bias frequently observed in behavioral finance investors, generally manifesting itself after major losses, but which can also occur following substantial gains.
Emotional biases
In the financial world, traditionally imbued with rationality, the crucial influence of emotions in the decision-making process is gradually being recognized. Modern portfolio theory faces a fundamental challenge in questioning the wisdom of ignoring these psychological aspects. Moods, influenced by external factors such as the weather and the days of the week, leave their mark on markets, with optimism often tinged with magical thinking. Optimism bias, marked by overconfidence, can lead to detrimental behavior, while risk aversion, considered a cognitive bias, translates into a reluctance to take financial risks. This aversion can lead to sub-optimal decisions, favoring safer gains at the expense of potentially more lucrative opportunities, resulting in a deterioration in portfolio performance. Pressure from the financial environment can exert a significant influence on investor decisions. Imitation, for example, can lead to market movements that are disconnected from the fundamental value of assets. When market players blindly follow the upward trend, prices may rise simply because of the mass effect, without any substantial new information to justify the increase. Similarly, group decisions are often tainted by individual psychological biases, amplified by the phenomenon of conformity. Giving in to the temptation to buy a stock simply because everyone else is doing so reflects a sheep-like behavior that can be detrimental to portfolio management based on objective data rather than external influences.
· The subjective value function
The subjective value function proposed by Kahneman and Tversky for evaluating risky projects reflects the previous characteristics of risk-taking behavior.
« Fear and the taste for risk »
Source : Daniel Kahneman et Amos Tversky, Pour la science, juillet 1999
On the other hand, the shape of the function in the loss zone (below the reference point) is not identical to that in the gain zone. More specifically, the shape of the value function above the reference point in the earnings zone is similar to that of the expected utility function, i.e. concave. On the other hand, it is convex and steeper below the reference point (loss zone), reflecting both risk-taking behavior in this zone and loss aversion (graph above).
It has been observed that early gains generate greater satisfaction, while large gains are often underestimated. Investors are inclined to take greater risks in the event of losses, seeking to recoup their losses, in contrast to a win situation where they tend to be more conservative. This phenomenon, known in behavioral finance as the “disposition effect”, translates into a propensity to sell winning assets quickly rather than cutting losses. In addition, fear of failure or the unknown often leads investors to avoid making decisions that could lead to potential regret, which can manifest itself after large losses or even after significant gains. This bias can lead investors to adopt an excessively cautious attitude in their choices, which can result in missed opportunities in the long term. For example, he might limit himself to selecting only “AAA” rated companies. Similarly, he may be reluctant to invest in currently promising markets because of past unfavorable experiences in those same markets, or he may be reluctant to enter declining markets for fear of making the wrong decision.
Furthermore, he may be tempted to follow market trends and rumors to avoid regretting his choices in the future, even though history has shown us the disastrous consequences of technology and real estate bubbles in the United States.
Finally, an investor may be inclined to hold on to winning positions for too long for fear of missing out on further gains, or on the contrary, to hold on to losing investments for too long for fear of making a loss.
In short, investment management can be a real headache.
In conclusion
The fusion of behavioral finance and risk management underscores the crucial importance of taking psychological and emotional aspects into account when making financial decisions. By recognizing and countering cognitive and emotional biases, financial professionals can anticipate market reactions and design more adaptive strategies. Approaches such as bias awareness, the use of technologies such as artificial intelligence, portfolio diversification, financial advisor expertise and effective emotional management can mitigate the effects of biases, enabling more informed and judicious decisions to optimize financial performance.
Since you’ve made it this far in your reading, we’ll give you a bonus : research has shown that investors who frequently scrutinize their portfolios are at greater risk of loss than those who consult them more sporadically. This correlation stems from the illusion of control : by closely observing the evolution of their investments, individuals may have the illusion of better control over their finances, but this constant monitoring can also amplify the perception of portfolio volatility, which can lead to erroneous decision-making. To illustrate, consider an investor aiming for a 10% return on stocks with 15% volatility. Over one year, the probability of observing a positive return is 93%, with a loss expected every 10 years. Over a month, however, this probability falls to 67%, with four expected losses per year. Over the course of a day, the probability drops to 54%, with 120 potential losses a year.
Finally, you should know how to distance yourself from your investments and take a vacation from time to time, for the good of yourself and your portfolio!
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Richelieu Gestion | Focus • March 2024
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