Smart and successful way of investing calls for a thorough understanding of behavioral finance not just market sentiments, crowd behavior or company performance. Evidence reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes.
Why is Behavior finance Important?
"Investing is not a game where the guy with 160IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get others people into trouble in investing." -------- Warren Buffett
According to conventional financial theory, the world and its participants are, for the most part, rational "Wealth maximizers". However, there are many instances where emotions and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economies and finance to provide explanation for why people make irrational financial decision.
Skewness of Asset Allocation Due to cultural bias
Behavioral finance can help people make better asset allocation and savings decisions, but it has less impact in te actual management of investment portfolios. This is because its lessons have not been fully learned. Investors seems to prefer stocks with a low probability of a very high return but the stock with high volatility and high return skewness show low future returns. To improve stock selection, behavioral tools should be used. Various articles claim that behaviorally managed portfolios have not achieved higher returns than those managed in traditional styles, such as growth and value. But lack of success is mostly due to the incorrect application of behavioral finance to the management of portfolios and that behavioral tools can help investors meet and exceed investment objectives.
Among the more puzzling phenomena in finance is the apparent negative empirical relationship between standard measures of risk and reward in equities. Established financial theory dictates that investors expect to be compensated for taking risk, yet the negative relationship between volatility and future stock returns is well documented.
Stock with a history of infrequent extramental positive returns without a commensurate frequency of similarly strong below average returns are said to demonstrate positive "Skewness". A behavioral preference for stocks with lottery like payoff leads positively skewed stocks to be "Overpriced" under the mean variance appear willing to pay a premium for stocks with high skewness. For portfolio where skewness is low, expected returns increase with higher level of risk consistent with Capital Asset Pricing Model (CAPM). This relationship is reversed for high levels of skewness where the assumption of normally distributed returns does not hold. On average, skewness increases with higher levels of volatility. As a result, stocks with both high level of volatility and high historical returns skewness exhibit extremely low future return.
Stock selection can be improved by the use of behavioral tools. Empirical academic research has highlighted two types of pervasive investor behavior which impact share prices, causing them to diverge from those predicated by the Efficient Market Hypothesis (EMH); under reaction of stock prices to news and overreaction or anchoring to a stream of good or bad news.
E.g.: A company that has just reported a positive earnings surprise due to some fundamental improvement in its business. If EMH held, then the stock price should immediately change to the new equilibrium price where all the information would be reflected.
However, in practice, analysts and investor will take a series of steps to fully reflect the new available information and, therefore, an investor who buys on the announcement of the news can generate a positive excess return. When a company's fortunes change from negative to positive and vice versa, investor ten to overreact and anchor on the past. As a result, it takes time for the change to be reflated in the share price. Similar in underreaction, an investor can generate excess returns by focusing on those companies where investor anchor.
Timely sales could enhance portfolio returns. Other potential behaviors include risk aversion, the tendency to sell young winners well before they have contributed their full alpha to the portfolio; avoidance of pain, a managers tendency to sell stocks as they are experiencing a substantial drop in price, and loss aversion, the reluctance to sell losers in hope of their possible recovery. Behavioral finance has been shown to positively impact investors financial decision making.
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