Behavioural finance is celebrating a big anniversary in 2012.
It’s been 10 years since Daniel Kahneman, a psychologist by trade, won the Nobel Prize in economics for having “integrated insights from psychology into economics” – an event that represented a coming of age for behavioural finance as a bona fide field of research.
The “prospect theory” that Mr. Kahneman and his long-time colleague, Amos Tversky, introduced in 1979, on which the Nobel honour was largely based, threw a wrench into traditional economic theory – and opened the door for a new generation of researchers to consider the role of human cognition, motivation and emotion in financial markets. “This whole notion really launched what has become known as behavioural finance,” said Stephen Foerster, professor of finance at the Richard Ivey School of Business at the University of Western Ontario. (Unfortunately, Mr. Tversky didn’t share in the Nobel honour, as he had passed away before the Nobel committee made its selection. Nobels are only awarded to living people.)
Prospect theory essentially argues that in situations involving financial risk, people care more about the value of their potential losses and gains than the probability of the outcomes. The result is that they can be more cautious or confident than statistical probability would dictate; they routinely misjudge the odds for success or failure.
Prospect theory spawned a mountain of increasingly detailed research over the past three decades. It raised questions about our basic understanding of successful investing. Concepts such as “tail risk,” “fat tails” and “black swans,” which found their way into the popular market lexicon since the 2008 market crisis, have their basis in the growing body of work surrounding investor reactions to extreme investing dilemmas.
“Investing is a matter of predictions,” said Arnold Wood, president and chief executive officer of Boston-based equity-portfolio-management firm Martingale Asset Management L.P., a long-time proponent of behavioural finance. “The question is: ‘How do you beat the market?’ And the fact is that not many people do … Why is that? That’s what behavioural finance is – it’s all hidden behind the question of ‘why’.”
Researchers have found that investors are overconfident in their own abilities and likelihood of success; they hold onto losses for too long and sell off gains too early; and they overestimate the value of increasingly complex, “expert” information in justifying their investment decisions.
The upshot is that investing is a lot less predictable and rational than we used to believe – a conclusion that comes as little surprise to anyone who has played the stock market in the past decade.
“The fact is that many domains are close to unpredictable,” said Richard Deaves, a behavioural finance professor at McMaster University’s DeGroote School of Business, in his recent review of Mr. Kahneman’s new memoir Thinking, Fast and Slow. “While it is true that the weather has a significant predictable component, financial, economic and political systems are much less predictable.”
Playing the odds
Three classic experiments from Daniel Kahneman and Amos Tversky, the modern fathers of behavioural finance:
1. Graduate students are told that they will participate in a coin toss, in which they will lose $100 if the coin lands on “tails,” but win an unspecified amount if the coin is “heads.” They are asked to indicate how much money they would expect to win on a “heads” in order to be willing to participate. On average, they wanted more than $200 – more than double the return that the statistical odds would justify.
2. In a lottery scenario, people are offered the choice between a certain win of $3,000, and an 80-per-cent chance of winning $4,000 but a 20-per-cent chance of winning nothing. More than 90 per cent choose the certain $3,000, even though the risk on the bigger win is statistically more profitable ($4,000 x 80 per cent = $3,200). But when the scenario is flipped around – people are told they can either lose $3,000, or have an 80-per-cent chance of losing $4,000 but a 20-per-cent chance of losing nothing, almost 90 per cent take the chance over the certain loss, even though it is statistically riskier.
3. People are told about a woman named “Linda,” who is 31 years old, bright, outspoken, a philosophy major. They're told she is concerned about discrimination and social justice, and has participated in anti-nuclear protests. They are asked whether Linda is more likely to be (a) a bank teller, or (b) a bank teller and an activist in the feminism movement. Nine out of 10 people choose (b) – even though the statistical probability of her being a bank teller certainly outweighs the probability of her being a bank teller plus something else.