Behavioral Finance

homo

Oeconomicus

The efficient market hypothesis of financial market theory makes two major assumptions:

Firstly, asset prices correctly reflect all available and relevant market information at all times. Secondly, fully rational market participants react directly to this information. It assumes that humans act as Homo Oeconomicus or economic human. Free from emotions and any cognitive limitations.

Accordingly, it would not be possible to generate excess returns through actively managed investment strategies. That is the common theory.

the

Reality

In recent years, criticism of the established financial market theory has increased. The idea of a fully rational human as a market participant has changed. This assumption is regarded as not in line with reality and not compatible with financial markets. As a result, the research field of behavioral finance has emerged.

Numerous empirical studies question the validity of the established capital market theory. These studies indicate that asset prices frequently do not exactly reflect the available information of certain phases. The reality is contradictory to market efficiency. Observable market anomalies can be grouped into different effects. These effects are called Value, Quality, Size, Yield, Volatility, or Momentum effect.

The existence of systematic price distortions, triggered by emotions, mood and cognitive limitations is the central focus of behavioral finance. Compared to the neoclassic perspective, this theory assumes that prices can systematically deviate from fundamentally justified price levels. Hence, investment strategies built upon behavioral finance insights can outperform markets and generate attractive results. The neoclassic perspective aims to describe a perfect world. Behavioral finance follows a different approach: it describes the observable behavioral patterns of market participants and tries to explain the resulting effects and price developments in the financial markets.

the

human behavior

Throughout the decision-making process, humans make errors of reasoning. These can reach from perception over processing all the way to the evaluation of information. We unconsciously use heuristics (rules of thumb) and are subject to biases. This can lead to misjudgment of probabilities, information, objective realities or even one's own ability. The appearance of different heuristics and distortions can be explained by means of cognitive psychology.

SIMPLIFICATION OF CIRCUMSTANCES

We reduce the perceived complexity by fading out information that is of minor or not obvious importance when assessing a decision. By using this approach, we spare our human resources regarding the perception of information. A good example of this is rounding or neglecting small differences in amounts. The inconsiderate use of this tool can lead to non-rational investment decisions.

CONTEXT EFFECTS

The human ability to concentrate is not constant and decreases over time. As a result, the information transmitted first in an information series is perceived more strongly than the subsequent information. This is the so-called primate effect. Subsequent information is thus overlain in its meaning by the information transmitted first. Affected information processing can result in irrational investment decisions. In addition to the primate effect, humans are also subject to the so-called priming effect. This effect states that later perceived information will be influenced by the first mentioned information, as far as they stand in the same context.

SELECTIVE PERCEPTION

Selective perception is known as a phenomenon whereby decision-makers do not consider all available information during the decision-making process. Instead, information is merely perceived selectively. Which information is taken into account depends on the respective personal ideas, prefabricated opinions, needs and expectations. If we have strong expectations, a high volume of new information will be needed to change or even refute existing expectations. As a result, high expectations might influence an investors capacity to notice clear warning signals regarding a stock or investment.

AVAILABILITY HEURISTIC

The availability heuristic describes the effect of giving too much importance to information with increased availability in the memory. Decision-makers consciously access this information. At the same time, less available information is knowingly ignored, neglected and suppressed. As a result, not all information is taken into account during the decision-making process. In addition, probabilities on the occurrence of events are systematically overestimated. This leads to a distorted picture of the truth. The availability heuristic ultimately leads to the overestimation of occurrences with higher availability and the underestimation of those with low availability by investors.

MENTAL BOOK-KEEPING

The heuristic of mental book-keeping is a form of complexity reduction during information processing. The notion of mental accounting stands for the conscious disregard and neglect of mutual dependencies between individual projects, purchase decisions or results. People tend to not mentally store the entity of projects or decisions in the aggregate. Instead, they are mentally stored and managed into separate and isolated accounts. Possible dependencies are not considered. Regarding investment decisions, this means that investments are often isolated and not viewed in the context of the portfolio.

ANCHORING HEURISTIC

According to the anchoring heuristic, people tend to process information based on a benchmark (anchor). The adaptation between two different pieces of information occurs gradually from the anchor towards the true value. There is nothing wrong with the process of gradual adaptation; However, numerous empirical studies show that this adaptation process usually falls out too short because the anchor used is given too much weight. This can lead to a distortion of expectations and to misjudgments, for example regarding the stock price development.

Hindsight Bias

We all know better in hindsight! People tend to judge the likelihood of events differently after the occurrence of an event than they would have before it occurred. In hindsight, they claim to have predicted the outcome of an event just as it ultimately did. "I knew it had to happen that way". This kind of behavior is called the Hindsight Bias. People who are subject to this bias tend to regard the observed results as the only possible consequence. Here, the insecurity regarding the development of an event as well as alternative results are clearly and systematically underestimated. This frequently causes a wrong sense of security, which in turn can lead to detrimental investment decisions.

Overconfidence Bias

The overconfidence bias describes the fact that decision makers systematically overestimate their own abilities and are thus overly self-confident. This can influence and distort expectations and the judgment ability of decision makers. They overestimate their own level of knowledge and the ability to make decisions independently and correctly. Ultimately, there is too much confidence in on one's own cognitive abilities. The accuracy of the decision taken is often overestimated, as it wouldn’t have been with a rational and objective view. This calibrates the expectations incorrectly and eventually leads to distortions in decision-making. As a result of overconfidence, the hazard of risk of loss or the duration of trend phases on the financial markets are regularly underestimated and thus misjudged.

LOSS AVERSION

The human approach of reacting to losses more sensitively than to profits is called loss aversion. It can be observed empirically that losses are weighted more heavily than profits of the same amount. If small profits are compared with small losses, the value measured to the losses are perceived as twice as high. The occurrence of loss aversion can be explained with the concept of cognitive dissonance and the human need for freedom of dissonance. Profits are generally perceived as positive and losses as negative. If a decision made leads to a profit, i.e. to a positive result, the desire for freedom of dissonance is fulfilled. However, a loss can easily lead to a cognitive dissonance. The justification of the losses to oneself occurs and psychological costs arise. As a result, investors may have a stronger tendency to invest in supposedly safe investments and shy away from long-term, more profitable but volatile investments.

ENDOWMENT EFFECT

The property effect, often called endowment effect, describes the effect according to which objects that are personal possessions subjectively gain in value. A damage due to the loss or sale of a personal possession is perceived as far greater than the benefits arising from the purchase of the same object. The subjectively perceived loss of value through the abandonment of an object consequently outweighs the benefit of preserving it. The property effect can be seen very well in the financial markets in the form of another effect. This is called the disposition effect. Investors tend to sell positions in profit rather than losing positions. There is a tendency for loser shares to remain in the depot longer than winning stocks. This leads to a reduction of the achievable yield. The sale of a losing position is often considered an "admission of mistakes". This is not coherent with the desire for consistent action.

the

Effects

The heuristics and biases used by humans lead to various effects in the financial market. The focus is on three findings: People systematically overestimate and underestimate information a swell as probabilities and future price developments. People tend to be risk-averse. People tend to herding behavior.

Market anomalies are the primary starting point of behavioral finance investment strategies. For decades, various empirical studies have shown the existence of different risk premiums on the stock market. For both equities and other asset classes, it is possible to forecast future developments with a certain probability based on historical price developments.

MOMENTUM EFFECT

It is possible to achieve an excess return by focusing on stocks that reached an especially positive chart-development in the preceding months. It has been observed, that shares showing high returns in the latest past will most likely act similarly in the following months and again achieve above-average returns.

VALUE EFFECT

It has been proven that companies with a lower price-earnings ratio achieve significantly higher returns than those with a very high ratio. An excess return can be attained by concentrating on these stocks that have a low price relative to their fundamental value.

SIZE EFFECT

More dynamic companies often generate higher returns than larger companies. By putting emphasis on smaller companies one can achieve an excess return accordingly.

QUALITY EFFECT

By focusing on stocks characterized by low debt, stable earnings growth and other quality criteria, it is possible to generate an excess return.

VOLATILITY EFFECT

On average, low-volatility stocks generate higher returns than stocks with higher volatility. Thus, it is possible to achieve an excess return by focusing on stocks with lower volatility.

YIELD EFFECT

By focusing on stocks with above-average dividends, an excess return can be achieved.


from theory to

practice

We use the results of our behavioral finance research to build our strategies which are the foundation of our investment solutions:

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