Magazine Issues » Dec 2008-Jan 2009

BEHAVIOURAL FINANCE: we're only human

Behavioural finance experts have been pondering the market collapse. Angele Spiteri Paris hears what they have to say...

A racing heart and churning stomach are universally recognised signs of panic and fear, the very signs that trigger the fight or flight response. This is also an apt description of antsy investors looking on as their funds risk crashing and making rash decisions as a result.

A glance at equity markets in recent months suggests that faced with the options of fight or flight, a large number of investors choose flight. These are scenarios that behavioural finance experts like to see and with emotions running wild in markets, they have been coming out of the woodwork to explain it all to us. Unfortunately, what they say seems so obvious: that greed caused the crisis, with fear and panic most likely exacerbating the sell-off in equities.

But they also say that if investors learnt about behavioural finance, then crises such as this would not be repeated.

Behavioural finance seeks to offer alternative explanations about why prices deviate from their fundamental values. According to Panagiotis Andrikopoulos, principal lecturer in finance at Leicester Business School in the UK, its key argument is based on the claim that human behaviour and perceptions represent two crucial elements of financial decision making. This led to the search for new models and ideas that may be able to explain and predict market behaviour from various psychological biases.

“Due to the illusion of control, knowledge, experience, etc and investors’ inability to understand and apply successfully their own knowledge to past and current information signals, investment behaviour can lack sound judgement leading to incorrect decision making, so as to give rise to the appearance of the evidenced mispricing phenomena,” he says in a paper.

This concept can be easily applied to the crisis we currently find ourselves in. The old adage that stock markets run on greed and fear has surfaced more than once in reports about the financial crisis. Hersh Shefrin, a professor of behavioral finance at Santa Clara University, who also teaches courses in behavioural finance at the Amsterdam Institute of Finance, says: “Sentiment is the reason
we are in this mess, in that it was irrational exuberance that produced the equity bubble and the housing bubble.

“Equity prices did not return to fundamental values until 2007. Even during the declines of 2000-2002, equity prices were above fundamental value. The problem is that not enough investors take the trouble to compute fundamental value.”

He adds: “The current financial crisis was driven by investors falling into deep psychological traps. If it weren’t for those traps, we wouldn't be in this crisis. Future crises can be avoided if investors the world over learn more about behavioral finance and put its lessons into practice.”

However, Shefrin warns that the undervaluation resulting from emotional overselling does not necessarily translate into investment opportunities. “From a behavioral perspective, the degree of mispricing often widens before it narrows. So there is short-to-intermediate sentiment risk exposure in betting to exploit market pricing.

“In addition, there is another argument which holds that equity prices became so overvalued during the late 1990s that the equity market has still not returned to fundamental value.”

Driving sentiment
So it seems that greed was a main cause of the crisis, while investors’ panic drove markets further down than they should have gone.

In the firm’s autumn Price Report, T. Rowe Price fund manager Mark Vaselkiv says: “At the heart of the whole cycle is greed. It’s not just a question of people doing stupid things just because they love the game and want to get ahead of the competition. They want to get rich, and that is why they ignore the risks.”

No one can easily deny that greed was a driving force behind the crisis, or that fear made it worse.  But behavioural finance expert Michael Pompian says that investors’ reaction to the chaos – dumping assets – is not the way to go.

“The panic is not justified. There has been overselling…[which has] for sure exacerbated the crisis,” says Pompian, a director of private wealth practice at Hammond Associates who wrote the book entitled Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases.

But he also says that stocks are now undervalued. “If you look at historical valuations, at the long-run price-to-earnings ratio and the level of earnings that the global economy can sustain then stocks are undervalued right now.”

Shefrin, of Santa Clara University, has also written several books on behavioural finance including Ending the Management Illusion. He agrees. “Yes, fear and panic did exacerbate the crisis and the majority of the panic selling has come from institutional investors, not individual investors…. Although the misguided past actions of certain institutions have indeed precipitated a global economic downturn that will be very severe, the responses in the financial markets have been excessive.

“To see this, you have to do fundamental analysis and understand just how much of fundamental value is determined by what happens, not in the next year, two years, or five years, but what happens ten years down the line and thereafter.

Pompian explains there were two major drivers behind the excessive selling. “You’ve got hedge funds that had too much leverage and now need liquidity. Some of them were not only needing to get liquid but they were also fearful that the market was going to fall and wanted to get into some cash.

“The second thing, in the US, is that the baby boomers are now entering retirement and people who are over 60 years old are now thinking to themselves: ‘I need money to live. I can’t take the risk in the stock markets so I’m selling’.”

Rational behaviour
Although most behavioural finance experts believe that investors’ panic selling has aggravated the crisis, the reaction of investors could arguably be justified given the inflated stock and commodity prices in the market before it all came tumbling down.

Rick di Mascio, CEO of Inalytics, says: “I think the crisis in confidence in markets and the dramatic falls we’ve seen are a function of the fundamental malaise of some of our financial institutions and failings of those who were previously assumed to be ‘masters of the universe’.

“There’s nothing wrong with emotions because we’re all human after all. It is about the degree to which you allow particular emotions, such as fear, to dominate your decision making.”

Other commentators agreed with the idea that investors are in no way being hasty, but simply taking reasonable precautions given the large number of toxic assets floating around.

“This is not panic. The panic hasn’t even started. What we are seeing now is completely rational,” says one senior investment manager. That should give behavioural finance gurus even more to talk about.

©2008 funds europe