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Psychology of Money


by daniel archibald

Have you ever looked at the equity market or a share price and wonder why it goes up and down like it does. From an individual company point of view, we have pretty good forecasts on how much money they're likely to make and most of the blue chips have pretty stable dividend policies. And its not like new information is coming to light every second or every day or even every week. So why should a companies share price change second by second?

In short, even though the market may be efficient, the market itself is still just a group of people, all trying to allocate their money as best as possible. And with different people come different behaviours and different biases, even towards the exact same information or event.

So what are these behaviours and biases that cause the markets to jump around so erratically or that cause shares to not be priced as efficiently as they should? The field of study which looks at this particular topic is called "Behavioral Finance" with the 2 main types of biases being mental/cognitive errors (bias/errors due to the fact our brains aren't perfect computers or try to find shortcuts to decipher new information) and emotional/psychological biases (bias/errors in decision-making due to irrationalities in our sub-conscious).

Common Cognitive Biases in Investing

  • Confirmation Bias - This occurs when you have an existing belief relating to an investment, and you only pay attention to news that matches your belief (e.g. you believe Sydney property is about to crash so you disregard articles or data that show otherwise and focus only only news that confirms an imminent price plummet);
  • Illusion of Control Bias - This tends to happen when people place undue weighting on how influential their actions are in determining the end performance of an investment or portfolio (e.g. a prideful belief that your stock selection is likely to be better than most others);
  • Anchoring Bias - This will occur when an investor places excessive focus on a particular price or level (e.g. you won't change the price at which you're willing to buy a stock even after new and significant information);
  • Availability Bias - This commonly occurs when investors remember events that stand-out more and forget events that may be less memorable and place a higher probability of the memorable event occurring again (e.g. you avoid investing in shares because the GFC is fresh in your mind, whereas the long-term upwards trend of equities is not).

Common Emotional Biases in Investing
  • Loss Aversion Bias - This occurs when an investor has a strong preference to avoid losses rather than achieving gains (e.g. you hold onto a share that has gone down in value as you want to recoup the loss first);
  • Self-Control Bias - This occurs when an investor puts short-term pleasure ahead of long-term pursuits (e.g. you fail to save adequately for retirement due to overspending);
  • Status Quo Bias - This tends to happen when investors become comfortable with their current portfolio and prefer to not make changes, even if they would most likely be beneficial (e.g. maintain an overweight to Australian shares as opposed to global shares because you are used to having mostly Australian shares in your portfolio);
  • Regret-Aversion Bias - This occurs when you would rather not make a decision or make a change because you're scared you might be wrong (e.g. not make appropriate portfolio changes because you're scared the changes might not be beneficial).

As markets are not run by super-intelligent cyborgs (yet) asset prices are still likely to show some irrationality and inefficiencies. Even with the many fund managers trying to exploit these and bring prices more in line with fair value, short to long term price discrepancies are likely to continue. Overall, understanding what biases you as an investor might have, and working out how to correct for these, can help you to maintain a more effective investment strategy.

 

LBW Financial Services Pty Limited is a Corporate Authorised Representative of Wealthsure Pty Limited (AFSL Lic. No. 238030)

LBW Financial Services Pty Limited is an authorised representative of Wealthsure Pty Ltd, AFSL 238030, ABN 93 097 405 108.  The information contained within these articles is of a general nature only.  Any rates (tax rates, Centrelink rates, exchange rates, etc) are correct at time of publication and are subject to change.  Whilst every care has been taken to ensure the accuracy of the material contained herein at the time of publication, neither the author, authorised representative, nor licensee will bear responsibility or liability for any action taken by any person, persons or organization on the purported basis of information contained herein.  Without limiting the generality of the foregoing, no person, persons or organization should invest monies or take action on reliance of the material contained herein but instead should satisfy themselves independently of the appropriateness of such action.