In this blog post, Part 1 of our two part series on Behavioral Finance, we explore human behavioral biases, how they affect us as investors, and how they are reflected in the stock market. In Part 2 of our series, we will explore the second required ingredient for profiting from behavioral bias: Limits of Arbitrage.

Human behavior is diverse and complex and, unfortunately, despite our best intentions, it is not always governed exclusively by rationality. In particular, our judgment and decision-making can be significantly affected by intuition, a form of abstract, automatic thinking that can override our reason.

Decades of research in psychology have shown that intuition is often systematically biased, and follows identifiable patterns, causing us to reach conclusions that are predictable wrong, since they are based on our gut or instincts, rather than on logic. An important aspect of behavioral biases is that they affect us in areas of our lives where it is very important that we be purely rational, such as in investing. In this blog post, we highlight a number of behavioral biases, and specifically how they can affect investors.

Before getting into the specifics, we wanted to review some background we hope will be informative, and put the biases into an appropriate investing context.

Market Anomalies

Clearly, investors can sometimes act irrationally. In particular, certain investment strategies have been shown to outperform expectations based on their systematic risk. These have collectively come to be termed “anomalies,” since they contradict, or are anomalous with, the Efficient Market Hypothesis, and these have been studied extensively by academics.

In recent years, finance academics have refined their understanding of several such return anomalies, including anomalies related to value and momentum factors. A quick refresher:

The value anomaly describes the outperformance of stocks that are inexpensive, based on any of several valuation metrics, as compared with their more expensive counterparts.

The momentum anomaly describes how stocks that have traded higher or lower in the recent past tend to continue trending in the same direction in the future.

These anomalies are well-established in the academic literature, but the question of why they exist began to draw attention.

Are Anomalies driven by behavioral bias?

Academics in recent years have sought to establish a connection between human behavior and these anomalies. Could they, in a sense, be the same thing? Recent research has increasingly integrated the findings of behavioral psychologists and financial academics, in ways that describe how human behavioral biases may be a fundamental driver of these anomalies.

It seems that our well-known behavioral biases affect investors in ways that have been shown to manifest themselves powerfully in securities markets. Below are a few of the biases, and how they play out in the stock market.

Overconfidence. Studies in psychology have demonstrated that, in general, people tend to be overconfident, across a variety of domains. In the stock market, humans systematically overestimate their ability to value firms, make earnings predictions that are too extreme, and they tend to overweight these faulty predictions. They become overly bullish about stocks they are optimistic about, or overly bearish with respect to stocks they regard with pessimism. Investors also suffer from self-attribution bias, attributing return outcomes that are consistent with their predictions to their own skill, but attributing outcomes that are inconsistent with those predictions to bad luck. This reinforces their overconfidence, and causes them to place even greater weight on their faulty predictions. Under certain conditions, these biases can create mispricings in equities, where market prices to deviate from fundamental value.

Representativeness. People tend to overweight salient evidence, which is easily available to our cognitive processes, and ignore statistical evidence that contradicts it, including base rates and sample sizes. For example, “growth investors” see a large increase in earnings and extrapolate it into the future, believing this growth is representative of future potential, when it may be attributable merely to luck. In this case, investors are overreacting, and ignoring lower base statistical rates for earnings growth while the reality is that high earnings growth is a rare event; they may therefore overvalue the company.

Conservatism. People are slow to change their views when given new information, and thus have an inherent bias towards conservatism. In investing, conservatism can drive “newswatcher” investors to underreact to news, and place insufficient weight on the new information, or valuable statistical evidence. As a result, investors may be slow to incorporate such useful information and undervalue companies, leading to stock prices that may lag their underlying fundamental value.

Anchoring. In psychology, it is well known that when people consider a number, and then are asked to make an estimate regarding a separate quantity, their estimate will be affected by the earlier number, even when it contains no information. In the IPO market, it has been observed that stocks recommended by underwriter analysts underperform those recommended by unaffiliated analysts. Why? These underwriter analysts’s views are biased. Underwriter analysts may become anchored on the views they form prior to the IPO, leading them to recommend stocks that have declined in value, but not to recommend those that have increased in value.

Loss Aversion. The literature of behavioral psychology has observed that evolutionary forces may favor individuals who focus on things that can harm them rather than on opportunities. Consequently, in financial terms, people appear to be more sensitive to losses, than they are to gains, and tend to be “loss averse.” This gives rise to the “disposition effect,” whereby investors are prone to holding onto losing stocks too long, since realizing the loss would be psychologically painful. Conversely, investors may take gains too early, which may delay the price discovery process, potentially contributing to a momentum effect as the stock continues trending upwards towards fundamental value.
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These are just a few of the biases out there, and with more research, we’re sure there will be more. We hope these have whetted your appetite to learn more.

The existence of these biases is a necessary but not sufficient condition to provide investors with an opportunity to profit from them. In order for an opportunity to be practically exploitable in securities markets, another condition must exist – there must be limits to arbitrage. This is the subject of our next post, Part 2 of our series, “Introduction to Behavioral Finance – Part 2: Limits of Arbitrage.”