Investments
Emotional
Rescue
Keeping feelings out of financial decision-making.
By Sophie Mayrand
B ehavioural finance, or the study of
investor psychology, marries the
psychology of decision-making
with investors’ trading behaviour
and asset pricing. Departures
from rational decision-making emerge
because individuals do not enjoy unlimited
information-processing capabilities and
instead rely on rules of thumb when making
decisions under uncertainty. This leads to
systematic cognitive errors and mispriced
assets. But behavioural finance helps us to
understand why certain market anomalies
exist and persist.
Efficiencies and Inefficiencies
The efficient market hypothesis, introduced
30 years ago, argues that information is
processed properly by investors and reflected
in the price of assets instantaneously. By
being rational, investors are expected to
update their beliefs correctly upon receiving
new information and, given those beliefs,
make choices that are normatively accept-
able to maximize their returns. Under this
hypothesis, active management is unable to
achieve superior returns to the market.
On the other hand, behavioural finance
proponents acknowledge that investors are
human beings who are subject to a range of
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emotions and information-processing errors
that push them to make suboptimal trading
decisions. This leads to mispriced assets and
inefficient markets. Investors who understand
and avoid these mistakes could exploit the
resulting inefficiencies and end up earning
excessive returns. With the discovery of
market anomalies such as the value premium,
the momentum effect and the post-earnings
announcement drift, it is tempting to search
for answers in human psychology to explain
investors’ underreaction or overreaction.
Common Biases
David Hirshleifer (2001) believed most
mistakes that individuals make can be
traced to four common causes: self-
deception (limits to learning), heuristic
simplification (rules of thumb), emotions
and social interaction.
Self-deception: Under this category,
we observe overconfidence, the illusion of
knowledge and the confirmation bias. How
many of us are guilty of thinking we are
better-than-average students, better-than-
average drivers and better-than-average
portfolio managers? While a majority of
us think that way, the truth is, the math just
does not work. We are simply overconfident.
The illusion of knowledge is the belief
september 2010 41

that the accuracy of our forecasts increases
with more information. More information is
not necessarily better information; it’s what
you do with the information that matters.
In fact, the dangerous thing about informa-
tion overload is that it actually increases
our confidence (overconfidence) but not
necessarily our skills.
The confirmation bias is our habit of
looking only for information that agrees
with our pre-existing beliefs; it is our thirst
for agreement. Because it feels good to have
our opinions reflected back to us, we search
for information that supports our views and
Confidence Breaker
Information overload is not only overwhelming, it’s also dangerous. Too much
information actually increases people’s confidence (overconfidence) but not nec-
essarily their skills. This has been proven in Stuart Oskamp’s classic experiment
(1965), showing how confidence increases as people gain more knowledge.
Thirty-two judges (psychologists and graduate students) were asked to read
background information about a case of adolescent maladjustment, divided into
four stages. After each stage, they had to answer 25 multiple choice questions
involving personal judgments. The results confirmed the hypothesis that as more
information was received by the judges, their confidence level would rise mark-
edly and steadily. However, the accuracy of their conclusions would quickly reach
a ceiling. (See figure below.)
� Accuracy � Confidence

ignore facts (or people) that conflict with 60%

our opinions.
50%
Heuristics: With rules of thumb,
individuals are subject to anchoring and 40%
representativeness. Anchoring is observed
when someone’s initial expectations or 30%
prior probabilities are based on a starting 20%
point (an anchor), which is adjusted when
new information arrives. While in theory, 10%
we should objectively consider the value 0%
of new information and arrive at a new Stage 1 Stage 2 Stage 3 Stage 4
predicted outcome, the fact is that we
always start with an anchor first and then Source: Stuart Oskamp (1965)
make adjustments. Investment profes-
sionals who entered the U.S. market in the
mid-1990s could not believe the market was
going anywhere but up before the turn of
the century, whereas those who witnessed
both the technology, media and telecom and
the credit crunch crashes are a little more
careful when assessing the relative valuation
of the market nowadays.
Representativeness causes individuals
to expect samples to be highly representa-
tive of the parent population from which
they are drawn. People see trends and
patterns in random events. They assign too
much importance to extreme and strong
new information and not enough to the
information’s weight or statistical stability.
For example, five spins of a roulette wheel
ending on black does not mean red is due,
just as five years of good earnings growth
does not mean the company can sustain its
competitive edge over the next five years.
The sample is just too small to be highly
representative.
Under the efficient market hypothesis,
investors are rational decision-makers when
faced with uncertainty. They weigh the value
of each alternative separately, then choose
the one with the highest expected return.
On the other hand, in prospect theory—a
positive model of judgment when faced with
uncertainty—value is defined as a change in
wealth around a reference point. For the same

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When faced with the certainty of a
$3,000 loss or a higher but just as probable
loss (80% probability of a $4,000 loss),
investors will go with the second option.
absolute amount, losses are felt with more
pain than the corresponding joy of a gain.
This is referred to as loss aversion. In addi-
tion, in the domain of gains, investors exhibit
risk aversion. They prefer a certain gain over
the possibility of a higher gain (e.g., they
prefer a 100% chance of winning $3,000 over
an 80% chance of winning $4,000).
In the domain of losses, however, inves-
tors become risk seekers. When faced with
the certainty of a $3,000 loss or a higher
but just as probable loss (80% probability
of a $4,000 loss), they will go with the
second option. The certainty effect gives
more weight to the outcome, more joy for
a certain gain and more pain for a certain
loss. Interestingly enough, when prob-
abilities are very low, the opposite occurs:
humans become risk seekers for gains (what
other explanation is there for purchasing
lottery tickets?) and risk averse for losses
(insurance premiums, anyone?).
Common Market Anomalies
Investors’ overreaction in extrapolating a
firm’s recent earnings growth and pushing
the stock’s price too high or too low has
been linked to the representativeness
bias. Based on relatively small samples of
earnings releases, investors will tend to
become too bearish on a stock that has been
performing poorly, pushing its price down
until it becomes relatively cheap and has a
better chance, going forward, to outperform
44 september 2010
its peers (the value premium).
The momentum and earnings surprise
anomalies are both seen as underreaction to
news. Momentum is the serial correlation
of returns that has been observed in various
parts of the world, whereby past winners/
losers outperform/underperform their peers
in the following one to 12 months.
Earnings surprise is the post-earnings
announcement drift in the stock price that
occurs when a company delivers earn-
ings that exceed/miss the consensus (the
surprise) and continues to outperform/
underperform (the drift) for subsequent
periods as long as six months into the future.
Conservatism, whereby we overweight our
prior views and underweight new evidence,
and anchoring (on past prices) can help us
explain why the release of new information
is reflected only in prices over time instead
of immediately, as the proponents of the
efficient market hypothesis believe.
The main take-away from prospect theory
is that investors tend to hold on to losing
positions for too long (loss aversion, risk
seeking and confirmation bias). Investors
simply hate to be proven wrong and love
to be proven right. This is exactly why
investors also sell their winners too quickly;
the certainty effect causes them to be risk-
averse in the domain of gains. (Remember
the old proverb: a bird in the hand is better
than two in the bush.)
Integrating Behavioural Finance
Into Your Investment Process
So how can investors avoid behavioural
biases while attempting to exploit the biases
of others? A quantitative process can help.
First, by focusing on a few crucial elements
for stock selection, you can avoid falling
into the illusion that more information is
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better. What are the most important factors Behavioural finance is both fascinating and fundamentals derived from the analysis
that drive a stock’s returns? Use this insight challenging, given the fact that investors of financial statements and the study of
on as many stocks as you can, instead of are all subject to cognitive and emotional investor psychology that creates mispriced
trying to know everything about a few. limitations. It also puts a human face to assets, investors hope to generate returns in
Second, by integrating an optimizer (an the black-box reputation of quantitative excess of the market over the long term. BC
investment software) into your portfolio investing. But while the understanding Sources available on request.
construction process, the memory-free of market anomalies can be insightful,
machine will not have an attachment to investors should avoid the overconfidence Sophie Mayrand is vice-president and senior
existing views when new information comes and the illusion of control that comes with portfolio manager at State Street Global
along. It will therefore be less subject to a additional information. By combining the Advisors in Montreal. sophie_mayrand@ssga.com
confirmation bias. Based on new evidence,
the optimizer will objectively evaluate the
new information’s value and arrive at a
new price estimate without the past price
being as relevant an anchor. The optimizer
does not care about a firm’s past earnings
pattern. If fundamentals and sentiment
are good today and value is appealing, the
optimizer will consider it for inclusion in
the portfolio. And because most optimizers
on the market have been developed using
an expected utility framework, they will not
fall prey to risk aversion or gambling in the
domain of gains or losses. If a better oppor-
tunity comes along—meaning investors will
have to sell a relatively worse-ranked stock
at a loss—the machine will not have second
thoughts about it.

The Five Financial Ws

The psychology of investing has been
embraced by more and more portfolio
managers over the past 15 years and has
produced a different approach to stock
selection and portfolio construction. It
does not replace sound financial analysis
but complements it by helping investors
to remove emotional elements from the
investment process. It brings investors’
attention to the five Ws they should always
ask themselves before adopting a ranking
process to select stocks:

1. What works?
2. Where does it work (in which
part of the investable universe)?
3. When does it work (up/down
markets)?

And by exploring the field of behavioural

finance, investors can get answers to the last
two Ws:

4. Why does it work?

5. Will it continue to work?

But is it really crucial to understand why

these anomalies exist? Is it not enough to
know that these biases exist and lead to
mispriced assets that can be exploited?

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