We often think that valuation is what we think of a company’s value. However, valuation is about what others think.
Behavioral finance theory states that markets are inefficient and investors are irrational. Investors’ psychological and emotional characteristics affect their investment decisions. In other words, markets are fundamentally made up of humans. And humans are irrational creatures.
“The markets can remain irrational longer than you can remain solvent.” —John Maynard Keynes
In his book Predictably Irrational, Dan Ariely, former behavioral economics professor at MIT, discusses common human biases and errors we are prone to committing.
Here, I will share how three cognitive biases link to investing and personal finance.
The Truth about Relativity
Take a look at the two black circles.
When placed among larger circles, the black circle seems smaller. But when placed among smaller circles, it seems bigger.
The black circle is the same size in both positions, of course, but it appears to change depending on what we place next to it.
This concept is known as relativity, and it can also be seen in mental accounting.
For instance, spending $3,000 to upgrade to leather seats when we buy a $25,000 car seems like an easy choice. But it’s difficult to spend the same amount on a new leather sofa, even though we know that we will probably spend more time at home on the sofa than in the car.
The concept of relativity plays a part in saving money too.
A study found that the majority of subjects contemplating the purchase of a $25 pen would drive to another store 15 minutes away to save $7. However, when contemplating the purchase of a $455 suit, the majority of subjects would not drive the same distance to save the same amount of money.
In reality, the amount saved and time involved are the same but people make very different choices.
Watch out for relative thinking; it comes naturally to all of us.
The Influence of Arousal
When arousal increases (i.e. the intensity of emotion increases), it influences your decision-making.
Real-world bubbles generate excitement and that excitement further inflates and sustains the bubble,” the researchers wrote in the paper, “Bubbling with excitement: An experiment”.
In a study, participants watched a short movie clip and recorded their emotional state after the video. There were three types of clips: exciting, scary or calming. Study participants watched only one video each and were misled into believing that the video was unrelated to the experiment. After watching the video, subjects embarked on a game involving the trading of real money and a fictional asset.
The results? Participants who watched the exciting videos were more aggressive in trading and traded their assets at much higher prices as compared to participants who watched calm or fear-inducing videos.
Excitement leads to relatively risky investment decisions.
We saw this play out in the recent GME saga. When the share price of Gamestop started to increase rapidly and news on wallstreetbets increased the excitement about the stock, investors flocked to buy the stock and pushed up the stock to over $300.
Knowing all this, it’s critical that we recognise how our state of arousal influences our investment decisions.
The Disposition Effect
The disposition effect explains that humans are innately risk-averse. We dislike incurring losses much more than we enjoy making gains.
Investors tend to sell winning stocks to lock in profits too early, and hold on to losing stocks hoping that prices will turn around.
Recognising the disposition effect and its influence on our investment behaviour should lead us to regularly review our investments.
Ask yourself, even as the market and economy changes has the underlying business changed?
Use logic, rather than emotion to guide your investment decisions.
Professionals Are Humans Too
What if we don’t want to DIY our investments, and prefer to leave it to a professional?
In the finance industry, one of the key competences of analysts, traders, and fund managers should be the ability to predict future developments better than others.
But are professional traders and analysts more “rational” than the layman?
In a study of 150 finance professionals from Northern and Central European countries, researchers found that level of experience does not prevent professionals from being prone to human biases and errors.
As outlined by the study, even the experts fall prey to framing effects and biases. Their expectations are systematically influenced by trivial frames such as price patterns. This shows that it’s necessary to debias professionals to make them less prone to framing effects.
Don’t trust professionals too much. Afterall, they are still humans and fall prey to human biases and errors.
Avoid Making Mistakes
Human biases such as framing and anchoring effects are hardwired into our brains, even for the experts.
Only by recognising our human bias in judgement and decision making can we overcome the bias.
Investing is not about always doing the best things in order to generate the largest gains.
Often, you can still do well if you learn how to “Avoid ruin at all costs” (Nassim Taleb).