|
|
|
Behavioural Finance
|
|
An Introduction
|
Behavioural Finance first emerged when Nobel laureates Daniel Kahneman and Amos Tversky made psychological risk research to question the assumptions of rationality popular in classical decision theory. How investors make decisions and behave has not been adequately described, and is of central interest in Behavioural Finance. Different risk preferences and perceptions have been identified. We have made further research in this field, and have derived important applications which are significant for the banking community.
Risk perceptions and preferences shape the initial investment decision, the evaluation, and subsequent decisions. Investors can fall into psychological traps and take unnecessary risk. How often do we take on risks we think we can handle but find we can’t? In addition, the popular way of measuring risk does not measure risk the way investors experience it. Indeed, this introduces significant difficulty in determining how much risk is appropriate. In our application of behavioural finance we offer a risk measure that is consistent with the client’s experience. With this measure we build risk profiles, optimal asset allocations for wealth management, and an advanced client advisory process. Please see What We Offer for more details.
The central theory in behavioural finance is prospect theory which describes how investors evaluate potential losses and gains in relation to a reference point. For one, it states that investors risk attitudes change when they experience losses as opposed to gains. Today, the common measure for risk is volatility. A portfolio with little volatility can be moving down smoothly, while a portfolio with a lot of volatility can be moving up in jumps and spurts. Which one do you prefer? Volatility measures how much a portfolio moves, but not the direction, and therefore is an incomplete measure of risk. Investors dislike losses, not volatility. In fact, investors react more to losses than they react to gains. Unlike volatility, the psychological risk measure is not the same for all investors, but is a characteristic of the individual. For this reason and others, the advantages of having a quality risk profiling procedure are innumerous.
An investor who is loss averse and evaluates his/her investment over the short term, as most do, is likely to gravitate to a lower level of risk. This means that he holds less risky assets like stocks. The reason for this behaviour is as follows: Whether their portfolio value moves up or down tomorrow causes a gripping reaction and seems more important than their long-term investment goals. This emotional reaction leads their behaviour to become inconsistent with their goals. Another distorting factor is that as people, we weigh probabilities in correspondence to what is important to us. Fantastic or severe outcomes we pay great attention to, even if their chances are small. We tend to over-weigh small probabilities, and this distorts our decisions. How is it possible to encourage consistent behaviour to promote achieving investment goals over the long-term? This situation of combined loss aversion and short-time horizons is described in myopic loss aversion, and can be compensated for.
We have established that investors behave differently in the domains of gains and losses, and that they react more to losses than gains. These are raw gains and losses, but there is another factor. It is possible to view the gains or losses everyday, or look at them yearly. Likewise, one may see the change in value of each individual item in the portfolio, or only see one total change. The different ways of looking at returns cause investors to react differently, so much so that if the mere presentation were changed the investor’s reaction would be completely different. This effect is called the framing effect, and must be handled carefully.
Investors evaluate and change their investments based on their perceptions, therefore the truly optimal portfolio must be optimal in the investor’s eyes. After risk profiling is complete and goals have been set, it is necessary for the client to know the value of his investment, so that he will act consistently with his investment strategy. If the client doesn’t think his investment is good, he isn’t going to keep it – even if his advisor says otherwise. It is necessary to build products which take into account how investors make decisions with regard to risk. Behavioural finance is about understanding client’s decision making process and behaviour.
We have applied these insights from behavioural finance to truly identify the client’s situation from a holistic stand point. With discoveries in prospect theory, myopic loss aversion, probability weighting, the framing effect and more, it is reasonable to say that behavioural finance gives attention to the investor’s experience. A more realistic investor as described in behavioural finance has different risk preferences and perceptions, and therefore wants a different optimal investment than the theoretical investor as described in classical decision theory. In this way, behavioural finance adds value to its predecessor.
|
|
|
|