• wblogo
  • wblogo
  • wblogo

Applying Behavioural Economics To Financial Markets

Blu Family Office, 17 July 2018

articleimage

This is the latest in a series of commentaries by the European family office firm.

Here is another in a regular series of commentaries by Blu Family Office.

The science of behavioural economics is still relatively new and only came to prominence in the last twenty years or so. It studies the effects of psychological, cognitive, emotional, cultural and social factors on economic decision making. No need to worry, this post is not going to get into deep intellectual explanations as to the origins, theory and complexity of the science. Rather, and much more pragmatically, we want to explore if we can use any of the inherent concepts to improve our investment acumen.

The first thing one has to understand when it comes to behavioural economics is that it is all about being human. Which also means, things are difficult to measure. After all, on a scale of one to ten, how much do I really like my morning coffee? But then again, all of us tend to be creatures of habit and just like any pattern based on historical performance data, so too can we find trends and cycles in human behaviour.

So, what are some of the things humans do that could help us make inferences on the stock market, for instance? 

We tend to overreact. Ever heard of the words “fear” and “greed” when we are experiencing (extreme) winning or losing situations with our monies? It is quite natural to get excited about betting on a stock and it then goes up by 200 per cent or going through the crisis of 2008 and thinking the world has ended. But emotions lead to irrational decision making by definition and so too in applying behavioural economic theory, we must pay heed to experiencing these situations and put in place plans to deal with them. Think stop-losses or profit-taking points before entering a trade. But moreover, recognise that these situations will occur (with or without your involvement) and as such, knowing that markets tend to overreact and overshoot, why not put in place some trades when prices do become extreme? If you had bought at the lows of the last crash in May 2009, you would be sitting on more than 400% in winnings in most equity markets. 

We change our opinion. Nothing can be more irritating than wanting to do one thing but then ending up doing something completely different. I often experience this on the weekend, when my plans are almost directly opposed to those of various parts of my family. But, also in financial markets, we can measure sentiment versus reality. The good news is, there are various surveys produced by polling companies (and academic institutions) that ask people their opinion on matters and then compare the findings to those done in the past. It can create some odd results, also owning to the statistical integrity (margin of error) one uses to conduct the analysis. But more often than not, these indicators do give reliable information as to changes of people’s opinions over time. Which allows us to apply these findings to understanding if the market has reached an overly bullish state, for instance, telling us it is time to sell.

We are lemmings. For those not familiar with the behaviour of these peculiar animals, they tend to follow the lead of the one ahead of them. Always, and even if it means running and falling off a cliff, one after the other. The expression hence became popular in the nineties, when no one could explain the astronomical rise of the stock market, other than by the behaviour of investors headed for doom. True as that may have been (and the bursting of the internet bubble), we also know the expression “the trend is your friend” and thereto one has to be careful not to dismiss this small furry rodent entirely. We can measure (so-called) lemming behaviour most obviously through so-called momentum indicators and as long as they are strong, a trend will stay in place. As such, one can profit quite handsomely following the lead for as long as the giving is good. But please remember, that humans are still a bit different than most animals, and as we can also change our opinion (see above). Meaning a trend can also very quickly turn, given a change in sentiment (of course).

Summing it all up, there tends to be a lot there in applying the study of human behaviour to financial markets, particularly for as long as humans still make most investment decisions. But I would also caution not to draw too much inference from the study of how we deal with emotions and how we make decisions. It is said, that 99 per cent of human decision making is subconscious. And as we really have no idea what is going on there, there is clearly also a limit to what we can hope to learn by studying a mere 1 per cent of our actions.

Latest Comment and Analysis

Latest News