Behavioural Finance and Emotional Biases
Behavioural Finance and Emotional Biases
Warren Buffett famously stated, “The most important investment decision you'll ever make is the one you make about yourself.” While this might not seem immediately related to traditional investments, it encapsulates a profound truth: self-investment, or personal development, is a crucial aspect of financial success. This is where behaviour and investment intersect, and emotions often come into play.
The market's behaviour over the last couple of years has challenged traditional valuation metrics and has demonstrated that market sentiment and speculation can often overshadow fundamental analysis. This increased market volatility and uncertainty have made investing more complex, and thus emotional biases can be a significant factor in decision-making.
Bias is a natural inclination for, or against, an idea, object, group, or individual which can be often fuelled by past experiences. The human brain is a vast repository of information, much of which is processed subconsciously. This unconscious processing can influence our decision-making, as past experiences and biases can shape our perceptions and judgments. This highlights the importance of understanding bias, the drivers and how to overcome them so we can make fairer decisions.
There are several emotional biases that are a common experience, even among financial professionals. These can include overconfidence, confirmation and herding and are notably prominent when the market is going through periods of correction. Investors can be tempted to “time the market” often resulting in mistiming moves out of and back into their investments.
Overconfidence Bias
Overconfidence bias relates to demonstrating unwarranted faith in one’s own abilities. This can be seen through the Dot-com bubble where many investors were overly optimistic about the future of internet companies during the late 1990s. This overconfidence led to sky-high valuations for many tech stocks, even though many of these companies had little or no revenue. When the bubble eventually burst market panic ensued through mass sell-offs of Dot-com company stocks and the event preluded the economic recession of 2001.
NASDAQ 100 Stock Index
Source: Bloomberg, Artorius
Confirmation Bias
Another common bias is confirmation bias, where investors seek out indicators and information that support their own notion and ignore data points which contradict these beliefs. In 2023, many investors expected a US recession but despite the widespread predictions of a “hard landing” and the Federal Reserve’s rapid interest rate hikes, the S&P 500 index was up nearly 20% year to date on July 31st 2023.
Some investors, clinging to the recessionary narrative, were slow to adjust their positions, only to be caught off guard by the market's resilience. This episode underscores the importance of remaining open-minded and adaptable to shifting economic conditions. As new data emerges, it is important to reassess our assumptions and be prepared to adjust our investment strategies accordingly. Those who remained overly fixated on the recessionary narrative may have missed out on market gains.
Herding Bias
Lastly, herding behaviour is a cognitive bias that leads investors to mimic the actions of others and has become increasingly prominent through the rise of the internet and social media. A notable example of herding occurred during the meme stock frenzy, particularly involving GameStop. During 2021, the consumer electronics retailer was facing declining sales and a challenging operating environment, leading many hedge fund managers to taking short positions on the company. However, through social media platforms like Reddit, retail investors coordinated efforts to drive up the stock price, motivated in part by a desire to squeeze the short positions of these hedge funds. This episode highlighted the market's vulnerability to collective action by retail investors, demonstrating the potential for their coordinated efforts to influence market dynamics. This period of high stock returns was unsustainable and left some retail investors significantly out of pocket.
GameStop (GME)
Source: Bloomberg, Artorius
How can we overcome our emotional biases?
Emotional biases, often rooted in impulse or intuition rather than deliberate calculation, can be challenging to overcome. However, by adopting specific strategies, investors can mitigate the impact of these biases and make more informed decisions.
Establishing clear investment goals and time horizons, coupled with a comprehensive analysis of diverse perspectives, including those that challenge our own assumptions, can help to counteract emotional biases and ultimately lead to improved investment outcomes.
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Market update
Last week, we discussed China's "Golden Week" and the anticipated stimulus measures. While there were expectations for more substantial stimulus, the initial post-holiday announcement fell short. The National Development and Reform Commission announced a spending package of only 200 billion Yuan, significantly below historical levels and market expectations.
In the United States, yesterday's economic data provided a mixed picture. Inflationary pressures persisted, with the Consumer Price Index (CPI) rising 2.4% year-on-year and core CPI (which excludes food and energy) increasing by 3.3%. This suggests that inflation may not be fully under control. However, the labour market showed signs of weakness, as initial jobless claims were higher than expected.
When analysing economic data, it's important to focus on trends rather than individual data points. While specific data releases may support different narratives, the overall direction of economic indicators is more revealing. Despite the recent decline in inflation, the Federal Reserve may still have room to cut interest rates. However, the likelihood of rate cuts will depend on the continued strength of the economy.
Rachael Faint,
Portfolio Analyst
Important Information
All expressions of opinion reflect the judgment of Artorius at 11th October 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions.
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