Human Psychology and Its Place in Finance

Posted: May 29, 2016

By: Jonathan Kim

The rationality of investors in their actions is an inherent assumption that frames all economic schools of thought; finance was born from microeconomics and is thus relevant. Traditional models and theories rely heavily on this yet, practical observations suggest otherwise. The consideration of behavioural psychology is a contemporary approach, revering the significance of the bias afflicting investors in creating more complete models. We herein seek to identify some of the common tendencies and their implications

Let us consider a simple scenario..

If you were to conduct thorough research on a specific asset, and found that it was very likely to be a profitable investment, rationally, you would invest in it. In the off-chance the asset performed poorly and you made a loss, you would be very unlikely to invest in that asset again in the future, even if it was the most economically rational choice at the future time. Conversely, if you had invested in an asset in the past that performed particularly well, you would be likely to invest in that asset again, even if economically superior options were available. Our valuation of these favored and unfavored assets often fall victim to confirmation bias – we only seek information we want to find on that asset and value subjectively. Our tendency to draw on past experiences in making decisions today result in emotionally motivated decisions which aren’t financially rational.

Source: http://boss.blogs.nytimes.com/2012/07/19/what-would-don-draper-do/?_r=0

Undoubtedly, even the professionals cannot act without an emotional motive or influence at times. It is however, the following steps of evaluation and critical feedback of their own performance which sets them apart from the rest of the players in the market, which we will now discuss.

There exists a large tendency for amateur traders (or more bluntly the uninformed) to fall victim to another form of bias known as self-attribution bias. The scenarios involves subjective analysis of individual performance where profits are attributed to smart investment choices and losses to ‘lucking out’. They become a victim to their own pride and hubris, often classified as carrying a god-complex, unable learn from their mistakes and objectively classify themselves as an unskilled trader. Why we associate ourselves with greatness in our learning stages clearly defines a form of delusion which occurs from association itself. Consider the time when you first obtained your driver’s license and thought you were an excellent driver until your first crash, or the times you self-proclaimed your singing abilities before hearing yourself on recording.

The initial stages of any practice we enter involves a stage of consciousness-raising, where the majority of individuals fail to recognize their own abilities. Small progress in the early stages can often trigger amplified notions of success, as we persuade ourselves I have a natural ability for this… Statistically that is an anomaly, and regardless, would require thousands of hours of working through to achieve a respectable standard.

Combining the micro factors of individual behaviour, we can observe the collective behavior or these individuals on a macro scale – the activity of this group is often labelled as ‘noise (Fischer-Black 1986)’. We define noise as a disturbance which prevents the full communication of an information set. This definition carries over to markets in which the irrational behavior of said traders prevents the pricing mechanism for securities to be perfectly accurate. The underlying causes of this joint behavior can be again attributed to human psychology.

Source: http://goldfunctionalwellness.com/wall-street-careers-can-make-you-very-rich-and-very-unhealthy/

From a psychological standpoint, there is a notion embedded in all individuals to be a part of the majority. We avoid scenarios where we are singled out and seek safety in numbers. These tendencies arise in the market as we observe ‘waves’ of trading in particular sectors or assets in the form of trend chasing. The strategies are formed on the basis of pseudo-signals, resulting in large demand shifts and distortions of security prices reflecting their correct value. As a consequence, these noise-traders either overvalue or undervalue the stock at their own loss, with the prices readjusted by informed traders who make profits based on this mispricing. The Big Short (2015) depicts one of the greatest examples of this, based on the US housing bubble of 2007 – the majority were oblivious to the imminent financial crisis, deluded by their belief in the safety of their collective actions and short term windfall gains.

The consideration of human behaviour in finance allows for an additional factor to be added to an already complex practice. Markets have only been around for 400 years or so and are still a developing concept. It would not be so far-fetched to suggest our knowledge is rather infantile, and that the complete resolution of financial markets is still a distant concept.