Financial markets have always been a cynosure investment heaven for retailers, institutional investors, and mutual fund managers. Rational and irrational investors and noise traders make abnormal risk-adjusted returns due to market inefficiency. Henceforth, financial markets investments, including equity, bonds, and preferential shares, have always been in the limelight for finance analysts, brokers, dealers, and investors.
Nevertheless, we must ponder the thought-provoking question of how investors and traders make their financial market decisions. Do investors’ portfolio creation, monitoring, and rebalancing based on the fundamental analysis, including the financial statements, equity valuation, and technical analysis? Or else, the market investors, traders, analysts, and fund managers are subjected to the sentimental heuristics and biases claimed to be mental shortcuts for judgments and financial decision-making.
To be precise, heuristics and biases are the salient features of System I, as explained by Daniel Kahneman in “Thinking Fast and Slow.” The System I intuitively operates automatically and quickly, with little or no effort and no sense of voluntary control.
Heuristics dominate the human brain’s innate cognitive ability to recognize patterns with bounded rationality. Herbert Simon, the economist and cognitive psychologist, first coined bounded rationality in 1950 and stated that rational decisions are supported by the involved costs and benefits in a limited period. Hence, investors have the cognitive limitations of the time frame and the asymmetric information for investment decision-making.
The conventional asset pricing framework and portfolio diversification principles are based on intuitive and fundamental assumptions. First, Investors are rational risk-averse arbitrageurs; second, markets follow the efficient market hypothesis principles, and the arbitrage opportunity exists with no transaction cost. Rationality intuitively implies that prices instantaneously reflect the entire information without any time lag whenever new information arrives on the market.
However, the fundamental market scenario is entirely different and pervasive, with the influence of heuristics and biases in investment decisions and portfolio diversification. The world of psychology is fascinating for its revelation that traders and participants are irrational on the market floors, as heuristics can instill confidence in irrational decision-making.
Behavioural finance significantly highlights the nuances of investor psychology and perception via anchoring bias, availability (recency) heuristics, home bias, disposition effect, self-attribution bias, hindsight bias, excessive optimism bias, and representative heuristics. For real-world investment decisions and portfolio diversification, the investors and traders inadvertently rely on heuristics. Financial markets exhibit complex dynamics with massive data sets for analysis, testing, and interpretation. The task is humongous to execute by the analysts, professionals, traders, and naïve investors.
The task is tedious, analyzing and bifurcating the financial statements for YoY growth, QoQ growth, and industry comparison. Markets are stochastic, and accurate prediction is challenging with minimum forecast error. Furthermore, technical analysis reveals the price charts, trends, and the absolute movements of stock prices in the financial markets. Noteworthy researchers, market analysts, and traders should extensively use technical analysis for rational investment decision-making. Nevertheless, fund managers, investors, traders, and market analysts need quick solutions and suggestions for investment decisions as markets are time-bound.
Heuristics produces fast, intuitive thinking, also known as System I thinking, which is useful as a rule of thumb and yields adequate positive gains. But sometimes, these heuristics lead to biases, described as systematic, predictable judgment errors. Let us understand the heuristics’ nuances and their impact on investment decision-making. Anchoring bias intuitively explains how the investors are reluctant to change their initial position and underreact to the newly available information. Rational traders follow the adaptive market mechanism and instantly incorporate the new information into the prices. Nevertheless, the investors who suffer from anchoring bias prefer the first information and arbitrary values and give the least preference to the latest information.
As a result, the investors do not adjust prices as per the market demand and supply and suffer substantial losses. Along similar lines, investors are susceptible to availability and home biases. Investors, traders, and fund managers judge the probability of the occurrence of any financial market decision-making. Nevertheless, availability heuristics makes investors end up with poor portfolio construction and investment decisions because all information is not equally “retrievable” or available with relevance at their disposal. Availability heuristics functions based on memory, and memory is vivid. The most recent events always weigh more weight. In hindsight, investors, traders, and fund managers rely on recent information rather than systematic market analysis. In reality, the traders’ market decision-making is prioritized based on recent information rather than market fundamentals accuracy.
For instance, investors are always attracted to the stocks and bonds that catch public attention because these are in the limelight and news for volatility, volume, returns, and P/E ratio. Investors tend to consider portfolio construction and diversification with the limited available stocks and bonds rather than the entire set of sample fundamentals analysis. Furthermore, theoretically, a financial market participant should have efficient portfolio diversification. The international portfolio diversification approach advocates attaining average returns while reducing portfolio risk. Home bias emphasizes over-investments in domestic financial instruments and equities rather than having international investments and diversification. Investors favor domestic stocks and bonds due to more favoritism and home bias.
Home bias significantly affects the systematic risk of the portfolio, and as a consequence, it affects the returns of equity holders. In the recent past, the susceptibility of investors to realize losses increased substantially. With the advent of the “Prospect Theory,” the perception of risk aversion is changed and one more feather is added to the utility maximization principle in equity investing. Finance theory highlights that investors should ideally be loss-averse and riskaverse. Nevertheless, it has been profoundly observed that equity holders sell the profit-making equities and always hold the loss-making securities with the anticipation of price recovery to the minimum principle level to avoid losses. This contrasting behaviour is known as the disposition effect in the financial markets.
The human psychology of holding loss-making securities is to avoid loss realization, and as a result, investors are riskseeking in the markets. The disposition effect violates the standard finance principles of risk aversion, utility maximization (returns maximization), and rationality. It is a conflicting argument to witness that investors hold the loss-making units and sell the winners or gains-making units in the markets. Investors, traders, and fund managers are also subjected to self-attribution and hindsight biases. Individuals have this cognitive bias to attribute the event’s success to personal skills and attribute failures to factors beyond their control. This cognitive bias is an influencing factor to create bubbles in the markets.
The sequential successful risk-adjusted stock returns create this influence that the decisionmaking is attributed to own skills and judgments. As a result, investors invest and trade bullishly based on selfattribution bias rather than financial fundamentals. Therefore, investors make biased decisions, resulting in higher market volatility and, consequently, volatile returns. Furthermore, the advantage of the heuristics is to assist in alleviating the cognitive load. Similarly, excessive optimism adversely affects the investment portfolio by overestimating favorable events and underestimating unfavourable ones.
Hence, investors and traders display unrealistic abilities and prospects when they suffer from optimism and end up with herd behavior in the markets. Excessive optimistic outlook traders and fund managers undermine the persistent level of risk in the markets. Moreover, investors presume that the financial assets they select or the portfolio diversification approach they adopt is efficient. Undermining the risk associated with the financial marketable securities and portfolio yields investors substantial losses in the financial markets. Ultimately, the rational suggestions to the investors and traders are not influenced by the representation heuristics bias.
In financial markets, if investors have snap judgments of good companies versus good investment analysis based on few available traits, likely to result in hasty and erroneous decisions. Representative bias is the tendency of investors to perceive past performance for future prediction. Nevertheless, markets are stochastic. Today’s good companies with good returns would not necessarily be good returns creators in the future. Past earnings may be an inappropriate guideline for future representations. Henceforth, investors and traders should alleviate the representation bias via full knowledge, fundamental financial analysis, and company evaluation. In a nutshell, we summarize that investors and traders are susceptible to behavioural biases in investment decision-making.
Research evidence reveals that more financial literacy among traders and investors is less prone to sentimental biases during investment decision-making. The research findings suggest that investors and traders can avoid cognitive biases by selecting the company stocks based on company analysis and equity valuation rather than mental shortcuts. Past winners may become the future loser and current losers will become winners in the future. Henceforth, the best financial evaluation will improve personal investment decision-making in the financial markets.
Jyoti Kumari is an Assistant Professor in the area of Finance at ICFAI Business School.