Insights & Stories

Written by Philippe Becker

If one were to ask an academic if the financial markets are efficient, most of them would answer yes. Since the 1950s and the advent of “Modern Portfolio Theory” financial analysts have mostly believed that markets can be described by well-supported mathematical models. In the past two decades, however, an increasing proportion of students of the markets will tell you that markets are not efficient, and point to the behavioral finance studies to support that assertion. In fact, we have gone full circle. In the early 20th century, most analysts believed that markets were driven by psychology:today’s investors, the conscious targeting of absolute risk isn’t just important—it’s essential.

From an evolutionary perspective, behavioral biases are embedded in our DNA and our decision-making process. Our brains are designed to react instantly to danger, and this ability to quickly estimate risk helped our ancestors avoid imminent dangers. When faced with an immediate threat, we tend to rely on our instincts and intuition rather than logic. These mental shortcuts are vital in a life-or-death situation, but they can cause the wrong type of reactions at times when more logical and analytical reasoning would benefit us significantly more. When our wealth is at risk, market volatility can feel as threatening to us as the dangers faced by our ancestors when living in an ecosystem populated with predators.

What are the biases that investors are subject to and why do they matter? There are multiple reasons for becoming intimately familiar with these concepts and the reasons include;

• Recognizing when we are subject to bias and emotions and resisting them so as to avoid poor financial decisions;
• Recognizing when the markets seem to be propelled by psychology (e.g. during times of market bubbles).

At Sapiens we pay careful attention to the possibility that our clients might exhibit biases and we help them recognize and control them so as to optimize their financial journey and maximize their return-to-risk ratios. Let’s explore a few of the most common biases.

Confirmation bias:

Confirmation bias describes our underlying tendency to notice and give greater credence to evidence that fits with our existing beliefs, and dismiss evidence that contradicts it. Confirmation bias can lead to poor decision-making as it distorts the reality from which we draw evidence. People who support or oppose a particular issue will not only seek information to support it, but they will also interpret news stories in a way that upholds their existing ideas. Examples of confirmation bias include:

• Only seeking out information that confirms our beliefs and ignoring or discrediting information that doesn’t support them;
• Selectively remembering information that supports our views while discounting information that does not;
• Having a strong emotional reaction to information that confirms our beliefs, while remaining unaffected by information that does not

The result of confirmation bias is that we make faulty decisions, based on evidence that has been distorted by our bias. How do we then combat confirmation bias?

• Be aware of bias and notice when it is affecting your reading of an equity analyst article or a news story, as examples. Reread the article paying particular attention to evidence that contradicts your assumptions;
• Make a conscious effort to try and disprove your hypothesis (the scientific method to test a hypothesis);
• Check if the evidence that might disprove your evidence is strong enough to make you change your opinion and do not hesitate to do so if the evidence warrants it.

To quote John Maynard Keynes, “When the facts change, I change my mind. What do you do, sir?”

Herd Mentality:

Markets are often driven by greed and fear. How does this work?

We have a tendency to be overly influenced by the actions of others. This again comes from our prehistoric days when there was safety in numbers. Following the herd gives us a sense of security. Unfortunately, a herd mentality can be counterproductive when in the financial markets.

A financial crash can induce panic selling, when in fact staying in the market or even taking advantage of the lower pricing would be the more productive step. Market booms also lead to herd mentality as investors feel they are falling behind their peers and end up buying assets whose price has skyrocketed – despite pricing not being supported by the fundamentals. Such investors will eventually lose when the bubble inevitably implodes, like the South Sea bubble of 1711-1720 in Britain.

How to combat herd mentality? Well we have the Warren Buffet strategy, “sell on greed, buy on fear”. We must try to stop our impulses and take the time to do thorough research before following the herd and falling prey to the “madness of crowds”.

Behavioral finance and biases are an important component of the wealth management we have worked on with our clients at Sapiens to optimize their portfolios and maintaining them over time. Disciplined investing and time in the market, vs timing the market, are important wealth principles and our investment philosophy.