The Importance of Behavioral Finance in Investment Decisions

Finally, one of my favourite and top Behavioral  Economist Richard H Thaler from University of Chicago won the 2017 Nobel Laureate in Economics, joining another top behavioural economist like Robert J. Shiller and  Daniel Kahneman in the list of Nobel Laureate.

He has been recognized by much insightful research link to the economic decision and psychology like “ Endowment Effect “ and “ Mental Accounting “ and also a writer of many best-selling books in economics and behavioural finance.

Concept Explained: from Investopedia

DEFINITION of 'Endowment Effect'

In behavioural finance, the endowment effect describes a circumstance in which an individual values something which they already own more than something which they do not yet own. Sometimes referred to as divestiture aversion, the perceived greater value occurs merely because the individual possesses the object in question. Investors, therefore, tend to stick with certain assets because of familiarity & comfort, even if they are inappropriate or become unprofitable. The endowment effect is an example of an emotional bias.

BREAKING DOWN 'Endowment Effect'

Studies have shown repeatedly that people will value something that they already own more than a similar item they do not own. According to the old saw: a bird in the hand is worth two in the bush. It doesn't matter if the object in question was purchased or received as a gift, the effect still holds. 

People who inherit shares of stock from deceased relatives exhibit the endowment effect by refusing to divest those shares even if they do not fit with that individual's risk tolerance or investment goals, and may negatively impact a portfolio's diversification. Determining whether or not the addition of these shares negatively impacts the overall asset allocation is appropriate to reduce poor outcomes.

This bias applies outside of finance too. A well-known study which exemplifies the endowment effect, and has been replicated over and over, starts with a college professor who teaches a class with two sections: one which meets Mondays and Wednesdays and the second which meets Tuesdays and Thursdays. 

The professor hands out a brand new coffee mug with the university's logo emblazoned on it to the Monday/Wednesday section for free as a gift, not making much of a big deal out of it. The Tuesday/Thursday section receives nothing. 

A week or two later, the professor asks her students to value the mug. The students who received the mug, on average, put a greater price tag on the mug than those who did not. When asked what would be the lowest selling price of the mug, it consistently averaged significantly higher than where the students who did not receive a mug would pay for it.

What is 'Mental Accounting'

Mental accounting is an economic concept established by economist Richard Thaler, which contends that individuals divide their current and future assets into separate, non-transferable portions. The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviours.

BREAKING DOWN 'Mental Accounting'

The importance of this theory is illustrated in its application towards the economic behaviour of individuals, and thus entire populations and markets. Rather than rationally viewing every dollar as identical, mental accounting helps explain why many investors designate some of their dollars as "safety" capital which they invest in low-risk investments, while at the same time treating their "risk capital" quite differently.

Many people use mental accounting, they may not realize how illogical this line of thinking really is. 

For example, people often have a special "money jar" or fund set aside for a vacation or a new home, while still carrying substantial credit card debt. (For more insight, see Digging Out Of Personal Debt.)

In this example, money in the special fund is being treated differently from the money that the same person is using to pay down his or her debt, despite the fact that diverting funds from debt repayment increases interest payments and reduces the person's net worth. 

Simply put, it's illogical (and detrimental) to have savings in a jar earning little to no interest while carrying credit-card debt accruing at 20% annually.

In this case, rather than saving for a holiday, the logical course of action would be to use the funds in the jar (and any other available monies) to pay off the expensive debt.

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In his famous book “ Nudge “ written together with Cass R. Sunstein, they change the way we think about choice and decision making. Every day, we make decisions on topics ranging from personal investments to schools for our children to the meals we eat. Unfortunately, we often choose poorly. 

The reason, the authors explain, is that, being human, we all are susceptible to various biases that can lead us to blunder. Our mistakes make us poorer and less healthy; we often make bad decisions involving education, personal finance, health care, mortgages and credit cards.

Many have been written about how the “ little nudge “ will have a big impact on some of our behaviour in decision making e.g saving for retirement.

4 Ways Nobel Prize Winner Richard Thaler's Work Has Improved Your Life

 Behavioural Economist Richard Thaler on the Key to Retirement Savings

Richard Thaler Wins the Nobel in Economics For Killing Homo Economicus

-- Economics is About People, not Blind Theories. There are a lot of grand theories in economics and what moves markets and money. But when you distil what's happening, it's about emotions and decisions that are not in our best interest.

Same may apply for investing, the market is about people and psychology not only a quant and figures. We need to understand the behavioural of “Mr Market “ and of course ourselves, like our own biases such as “ Overconfidence “, “ Confirmation Biases “, “ Loss Aversion “, “ Framing and Anchoring “ etc.

I have collection of 5 books written ( Edited ) by Prof Richard Thaler :

1)      Nudge

2)      Mis-Behaving

3)      The Winner’s Curse

4)      Quasi Rational Economics

5)      Advance in Behavioral Finance ( Edited by Richard Thaler )

Please find out these from the bookstore or library for your weekend reading. The first two should be easier to read and the last two are more advance which needs some basic economic background.

In summary, behavioural finance is a field of finance that suggests the theories based on psychology in order to explain the concept of stock market anomalies which include extreme rise and fall (boom and bust ) in the prices of the stock market. Behavioural finance suggests that the structure of the information and characteristics of participants of the market play an important role in the decision making of the investors as well as the overall the outcome of the market.

Further reading on topics of Behavioral Finance :

8 Common Biases That Impact Investment Decisions (From Investopedia.com)

Behavioural Finance and Key Concept (From Investopedia.com)

7 ways your brain makes you a terrible investor ( From Business Insider.com)

And of course, reading my blog on My Investment Strategy : 3 Ts 3 Ms ( part 3)

In order to make the best decisions that are free from any type of emotions for the financial investment one need to stay rational and understand the limitation of our brain structure in day to day decision making. Our brain and its composition have gone through a lot of evolution to date. The current composition is originated from the old times of the Stone Age when the basic needs were to hunt for survival. The needs of that time were different from the modern age and digital world.

Behavioural Finance has been able to derive the behavioural patterns that can be combined with logical thinking. An individual who knows and understands these behavioural patterns is capable of knowing his abilities and improving them.

Cheers !!

Quote Of The Day :

 “The investor’s chief problem — and even his worst enemy — is likely to be himself.” Benjamin Graham