Momentum and Behavioural Finance
Momentum and Behavioural Finance
In an earlier piece I touched on the efficient market hypothesis, its centrality in developing modern asset pricing and portfolio management theory, and how subsequent developments in quantitative finance challenged the assumptions around efficient markets. This ultimately led to an evolution in theory and investing to encompass newly uncovered statistical anomalies that were shown to provide excess returns over the long term.
The focus in my last piece was my favourite statistical factor: momentum. But focusing on the development of quantitative finance since the late 1980s, and how it has influenced investment theory, tells only part of the story.
Concurrent with the development of quantitative finance, the field of behavioural finance was turning assumptions about investor rationality and behaviour on their heads, challenging models of investor behaviour that relied on investors being self-interested, rational, and risk-averse.
It All Started in the 1960s
Like the efficient market hypothesis, the genesis of behavioural finance lies in the 1960s. This time, though, instead of applying computing power to analyze asset prices, psychologists began to examine the mental processes that influence behaviour, focusing on empiricism and ultimately developing the field of cognitive psychology.
Most prominent amongst this new breed of psychologists were Amos Tversky & Daniel Kahneman whose focus on how humans make judgements led to their 1979 paper ‘Prospect Theory: An Analysis of Decision Under Risk.’ This was the seminal text that led to the development of behavioural economics and finance. Kahneman won the Nobel Prize in 2002 for his work in this area, six years after the death of his partner Amos Tversky.
Prospect Theory Findings
The key takeaway from the evolution of behavioural finance is that humans (as market participants) are in many ways less rational than homo economicus of the Efficient Markets theory.
In fact, there are three main findings in prospect theory that help explain market participant behaviour:
The way a problem is structured and a reference point or cognitive frame applied to it significantly influences the choice made. Humans operate from rules of thumb that may not be correct, and these may lead to suboptimal decisions (i.e., not rationally maximizing utility).
Gains are treated differently from losses. In fact, the potential for loss tends to be much more strongly felt than the potential for gain.
Outcomes that are felt to be certain are over-weighted relative to uncertain outcomes. This is, effectively, fear of uncertainty: it’s much easier to sit alone than take the risk to ask out on a date the intriguing person next to you and risking rejection.
Market Implications
This framework helps explain a lot of behaviour that we see from individual marketparticipants and the broader market. A few of the more common biases and their implications are:
Recency bias: The cognitive frame that recent events or experiences are more heavily felt and weighted in decision-making. This leads to a tendency for investors to extrapolate recent events into the future, while largely ignoring the less recent past. Added to this is the tendency towards regret avoidance (the kids these days call it ‘FOMO’—Fear Of Missing Out). This helps explain the herding behaviour that ultimately drives much of the momentum factor that I outlined in my earlier piece
Loss aversion: The tendency to weigh losses more heavily than gains: to be more afraid of downside risk than may be rational when that risk is weighed against related potential upsides. This is probably the one I encounter most often. The textbook example is the gambler who doubles down instead of accepting their loss and moving on, a behaviour that ultimately increases their risk exposure:
This extends to the fear of loss that essentially all changes from the status quo represent. Often what prevents people from taking action when contemplating change, even a much-wanted change like losing weight or getting healthy, is the fear of loss and fear of uncertainty that change represents.
The status quo: Even if painful, it can be comfortable because it is certain: the typical human bias to stick with the “devil” he or she already knows. Taking this back to financial markets and business decisions, loss aversion and the related fear of change often presents as an obstacle to management teams taking proactive steps to mitigate uncompensated risks. Like FX volatility: another example of how cognitive frames and the behavior they influence can lead to suboptimal outcomes.
Conclusion
The work of Daniel Kahneman, Amos Tversky and other behavioural economists like Richard Thaler goes a long way in explaining persistent market phenomena that don’t tie in with rational decision-making (we aren’t all as rational as Star Trek’s Mr. Spock). It is often thought that financial markets are meant to be efficient and rational; the reality is often different.
Financial markets are the product of human endeavour ), and as such are also influenced by our own very human shortcomings. The conceit of rational economic actors is a good one for building analytic frameworks, but as history and evidence show, economic decisions are subject to the same bounded rationality and errors in judgement-- and thinking patterns that are part of the human condition.
Since markets are an aggregation of human decision-making and human-constructed systems, the biases, schemas and styles in which we process information as humans show up in how we behave.
Knowing this, like knowing oneself, ultimately can lead to better decision making.
Read the previous article in the series: The Trend Really is Your Friend (Sort Of)
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