Mind Games
Behavioural Finance
Logic, sense and rationality drive most investment decisions, correct?
Actually, fear, greed and ego are some of the biggest influencing factors
in stock markets and the sooner we accept that, the better investors
we can be.
The myth of rational markets
Once upon time, many investors and economists including a few
Nobel Prize winners subscribed to the idea of the efficient market
hypothesis. Thats the theory that all relevant information is rationally
priced into a market as soon as it becomes available. That, in turn,
renders it difficult to outperform the market for any decent period of
time as the price of stocks and shares will quickly reflect their fair value.
But numerous anomalies in market valuations have challenged this
idea. Indeed, the regular occurrence of stock market bubbles followed
by sharp corrections suggest that something far less rational is at work.
Thats perhaps not surprising when you remember that stock markets
are ultimately thousands of human beings making decisions to buy and
sell which means that emotions, biases and assumptions are bound
to come into play.
Plotting our behaviour
But just because the market is often irrational doesnt mean its wholly
unpredictable. Economists and market theorists over the past 20 years
have looked to categorise the unconscious human behaviours
or cognitive biases that influence decision-making. In this series well
be looking at some of the most prevalent behaviours. Well show how
even the smartest of us can be fallible to our emotions when making
all kinds of financial choices and what we can do to help us make
smarter decisions.
1. Behavioural biases: Anchoring
Making an informed decision can be tough. Given all the information
and noise bombarding us, it can be tricky to know what to take notice
of and what to ignore. Which is why, both in investing and other areas
of life, we will tend to latch onto irrelevant or insufficient information
to guide us.
These anchors can include past events, rules of thumb or even a
single fact weve chosen to fixate on to, just to help us arrive at a
decision even if new and conflicting information becomes available.
(Indeed, people often will focus on the facts that justify a decision
theyve already chosen to make a confirmation bias well explore
in a future instalment of this series). Here are a few examples
of anchoring:
i. Past imperfect
Q: For the past four years, a stock market has delivered an annual return
of 10%. This year, however, it has delivered a return of 5%. What would
you accept as a reasonable annual return from this market for the next
5 years?
A: Did you guess around 7.5%? If so, youre probably not alone
most people would try to average the two figures they have been given.
But what if we now tell you that the average return for this particular
market for the past 10 years has been just 3% a year? Would you revise
your forecast?
This illustrates two things: one, the danger of focusing on very recent Avoiding anchoring
events when making a value judgement (and nowhere are memories The Symptoms
shorter than in the stock market); and, two, how we tend to base You tend to focus on just a few fact when making decisions
opinion on past events. After all, why should past performance tell you
You are heavily influenced by the past when assessing the price of
what is a reasonable return to expect in the future?
shares and other investments
ii. False targets You find it hard to incorporate new information into your
Q: You hear that a house in a neighbourhood at sold for a record price decision-making
of 400,000. You purchase a nearby house for 350,000 as a buying
The Cure
opportunity. Average house values subsequently fall to 320,000.
Try to ignore an investment or assets previous performance and
At what price are you subsequently willing to sell?
concentrate on its future worth and market demand
A: Chances are youll be holding out for at least 400,000. Because this If you have a mental target for a selling price always ask yourself
is the price homes have reached in the past, its easy to become focused what it is based on, if its rational and incorporates the most
on this as the price they should be. In reality, you should be looking at up-to-date information
the overall market and demand for that neighbourhood. Are there any
Never assume a price should return to a previous high by rights
new external factors (e.g. plans for a by-pass) that are driving prices
NEXT TIME: Overconfidence
down for the foreseeable future?
iii. Rules of thumb
Q: A man earns 60,000 a year. He falls in love and wants to propose
to his girlfriend. What should he expect to pay for a diamond
engagement ring?
A: Did you suggest 5,000? While it makes no sense whatsoever,
clever marketing has inculcated into us that a diamond ring should cost
a months salary regardless of the fact of how pay rates have changed
since that marketing ploy was first devised in the 1930s. But if youre a
young man living in Europe count yourself lucky. In the US, adverts ran
recommending a spend of two months pay and in Japan, a price tag of
three months pay was marketed in the 1970s as a display of true love.

The value of investments and the income from them can go down as well as up and you may get back less than the amount invested.

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