How understanding behavioural finance can add value

Recent examples of irrationality in markets and individuals highlight signs for investors to look out for and opportunities for financial services professionals to coach their clients
by Tim Cooper


Scientific understanding of investor psychology is growing, helping skilled advisers save hundreds of thousands for clients over their lifetime. Nobel prize-winning academics such as Richard Thaler and Daniel Kahneman have shown that deeply-embedded behavioural biases – such as overconfidence, greed and fear – drive most investment choices.

These errors cost the average uncoached investor between 1% and 4% a year in returns, depending on which study you read. Over 20 to 40 years, this could have a devastating impact on investment goals.

Behavioural forces in investment markets are not new, but they are arguably becoming more frequent and powerful with plenty of recent examples.

In February 2021, investors clubbed together to protect shares in retail company GameStop (see our article about gamification for more on this) against what they believed were overly aggressive short sellers. This successfully reversed its share price but then many other investors hopped on the bandwagon, greedily chasing up the GameStop price to 15 times its previous value, only to see it crash days later.

GameStop became a classic ‘meme stock’ – an investment story that goes viral, with retail investors irrationally boosting prices, attracted by online stories about its rocketing price. This can take prices well above fundamental values, based on the company’s projected cash flows.

Alongside social media, meme stocks have been powered by easy access to online share trading platforms. The phenomenon gives investors a dopamine-fuelled thrill but can have profound repercussions for those who don’t understand the high-risk gamble they are taking.

Meme stocks can be associated with several cognitive errors such as overconfidence, confirmation bias, and herd mentality as investors follow the crowd into unrealistically priced stocks, buying high or selling low.

Coin chaos

Cryptocurrencies such as bitcoin have often followed a similar pattern, with the promise of large short-term gains leading to wild speculation and market volatility. Software developers even created dogecoin as a joke to make fun of the wild speculation in cryptos. In 2021, its price spiked then crashed.

Speculating on cryptos is potentially even more dangerous than other assets. Though they do have real world applications and are increasingly accepted as currencies, it is hard to measure their intrinsic value as they have no physical assets.

Keith Robertson, a consultant specialising in investment risk and psychological biases, says, “People will always tend to go for an exciting story about stocks but there is an absence of critical thinking.”

Initial public offerings (IPOs) are another potential danger area for investors. Stock market flotations can be good opportunities to back upcoming companies, but there have also been many IPO flops recently, including Casper Sleep in February 2020, which slashed its valuation when it cut its IPO target range from US$17–19 per share to US$12–13 per share, and GoHealth in July that year, which priced above its expected IPO range of US$18–20 per share at US$21 apiece, but saw the price drop in afternoon trading, down to US$19 per share. It is easy for investors to get sucked into the hype around listings, especially in sectors such as technology with potentially exciting returns.

Greater Fool Theory suggests that technology stock prices can stay high  As so many technology stock prices have kept rising for years, in a way that bears no relation to their existing revenue or profits, some commentators have asked whether this represents a new paradigm in which prices can stay high regardless of current fundamentals.

Greater Fool Theory – part of the wider behavioural game theory that some apply to stock pricing – suggests fundamentals do not matter providing there is someone more foolish than you to buy your overvalued shares. The danger is that if or when the market runs out of fools, you could be left holding the stock when it implodes.

When the game stops

The GameStop story is a good example of game theory in practice.

Efficient Market Hypothesis states that, in perfectly efficient markets, stocks trade based on all information available to the market, making it impossible for investors to buy undervalued or sell overinflated stocks. Investors who want to beat the market must believe they are inefficient, due to other people’s cognitive flaws or other reasons such as imperfect information.

With GameStop, investors showed they could ‘game’ the market, working together to reverse market forces and influence a share price upward for a brief time. However, that effect did not last, and other forces re-established quickly.

One aspect of game theory that came into play was the Prisoner’s Dilemma, which shows why rational individuals might not cooperate.

The dilemma describes a situation where, according to game theory, two players acting selfishly will result in a suboptimal result for both. But it also shows that simple cooperation is not always in their best long-term interests either.

Initially, the individuals supporting GameStop had an incentive to work together, but this broke down when other investors sold their stocks, incentivising others to sell before the price fell further.

The research behind game theory – for example, from Stanford University (1997) – shows rational people are more prone to defect from an agreement than cooperate. They can initially cooperate to mutual advantage, especially in a smaller group of committed individuals. However, once the model becomes more complicated, for example as other less committed or aware individuals join, the original members realise that defection is in their interests.

The GameStop rebels also belonged to the much wider and more varied group – the entire equity market – which is why their revolt collapsed quickly.

The money pump

Some believe the trillions of dollars injected into economies by central banks in response to the 2008 financial crisis and the Covid-19 pandemic have made prices appear healthier than they are, making it harder for investors to assess asset and market prices rationally.

Keith Robertson says: “Central banks pumping more money into the system may prevent a crash, but it also creates a gigantic moral hazard because the global financial sector believes it is too big to fail. The result has been an extraordinary period of market price increases, which is not the same as value.

“Valuation metrics appear to be extending forever, but no market goes in one direction forever and, as Keynes said, ‘Markets can continue to be irrational longer than you can remain solvent.’”

Returns are dependent solely on one’s entry point into the asset price cycle Keith adds that it is essential to understand the concept of long-term fair value (LTFV). Over 200 years of data (Jeremy Siegel: Stocks for the Long Run) suggest the main public equity markets have provided mean annualised real returns of about 6–7%. But actual returns are dependent solely on one’s entry point into the asset price cycle. If one buys when the market is above LTFV, returns are likely to be below the long-term average. If the entry point is in the lower part of the cycle, one could reasonably expect above-average future returns. Tobin’s Q ratio (applied historically to the S&P500) can be a useful tool in assessing where the cycle currently is.

Central bank action has also kept interest rates well below historical norms, pushing investors to seek riskier assets to replace the safer returns they would have received from deposits, property and bonds. 

Good biases

Cognitive biases such as herding are not always damaging, far from it. A classic experiment showed that when large samples of people guessed the number of beans in a jar, individual estimates were often way out but the average was highly accurate.

More recently, this understanding of ‘crowd wisdom’ has developed into a theory of ‘swarm intelligence’, in which participants are constantly and dynamically cooperating and adjusting to reach highly accurate averages.

Diversification and time in the market clearly help mitigate these problems, but many advisers believe it is still crucial to understand behavioural finance, including why distortions such as meme stocks and tech and crypto bubbles happen. This helps them assess potential dangers in their investment proposition and is important for fully informed, educational conversations with clients and their children.

Keith believes a key educational message is that metrics for valuing property and equities are well established. In contrast, he says, the fundamental value of commodities cannot be rationally calculated for investment purposes.

He explains: “If one knew the true price of production for any commodity (energy, metals, hard and soft agricultural crops) then a chance to buy at below that might be worthwhile, but otherwise the day-to-day price of any commodity must be considered provisional. Obviously strong real growth in the global economy might suggest buying industrial metals would be a good bet, but it will always be just that – a bet, even if you think it’s an informed one. Take a look at the charts for oil and gas prices during 2021, and assess honestly whether such price fluctuations are what your clients are looking for, and how would you have predicted them?”

While commodities do have intrinsic value, that is often very different from their market price at any moment, he says. As a result, many commodity trading firms have gone out of business because they thought they knew what the correct price of their commodities should be. For example, scarcely a single international sugar trading house active in the 1970s and 1980s now exists.

By contrast, equities have fundamental factors such as corporate cashflows that should relate more closely to their pricing.

"Investments need an economic rationale showing why you’ll get a return – only cash, bonds, equities and property have that" Keith says this is why many things called investments aren’t; they are mostly purely speculative.  He says that “wine, art, and other ‘speculations’ are fine but only if clients fully understand the risks, including the fact that the price you can sell at is entirely dependent on the subjective opinion of a third party”.

Andrew Brook-Dobson CFP™ Chartered MCSI, managing director, BDB Financial, often coaches clients’ children on these issues as they often trade online. “The GameStop phenomenon gave an interesting insight into herd mentality with lots of younger investors involved, buying high and selling low,” he says. “We coach that investments need an economic rationale showing why you’ll get a return – only cash, bonds, equities and property have that. It doesn’t mean you can’t make money speculating on commodities or bitcoins, but they are not investments, they rely on Greater Fool Theory.

“Part of advice is protecting people from themselves, giving uncomfortable messages, challenging and educating them – that is all essential for them to give informed consent for their financial plans.”

To provide this coaching, it also helps to understand the tell-tale signs of psychological mistakes in individuals and markets. For example, a rapid but unexplained price change could indicate herd mentality. A sharp price change that is explained, but which goes beyond fundamental value, could be a sign of irrational panic or euphoria. Markets reacting to sensational news stories can indicate recency bias – the perception that the most recent things to happen are most important.

Hersh Shefrin, professor of finance at Santa Clara University, says: “Most investors, especially when trading stocks, pay little attention to fundamental value. They are more influenced by psychological phenomena such as excessive optimism, herding, overconfidence, and the greater fool dynamic. We are also beginning to understand the role of dopamine flows, for example, in the highs investors experience during a market bubble.”

Portfolios satisfy a range of financial and psychological needs, from short-term dopamine hits and social status to long-term lifestyle funding and peace of mind, says Hersh. “Advisers therefore need serious conversations with their clients to figure out what all these needs are, and their relative strength and importance. That sets the stage for honest conversations about perceptions and potential biases.”

Hot money

Saran Allott-Davey CFP™ Chartered MCSI, managing director, Heron House Financial Management, says clients often need educating that short-term volatility is not their biggest risk, providing their liquidity is well-managed. Instead, their biggest psychological tripwire is not taking enough risk to maintain living standards.

Knowledge of behavioural finance is helpful in talking to fund managers about how various themes, such as ‘hot money’, may affect portfolios, and as background for client conversations, she says. But she avoids going into great detail with clients as it overcomplicates the discussion.

“Our job is to simplify life for clients,” says Saran. “But if they are about to make a bad decision due to behavioural biases, we help them correct that. So, we need a thorough understanding of what motivates them.

“We don’t buy individual stocks for clients as we think well diversified funds are a better way to access stock market returns. Beyond that, it mostly comes down to understanding when clients need access to their money and how much they need; and ensuring they are well-educated, understand market moves can be quick and exaggerated, and don’t panic about short-term volatility.”

Behavioural finance discussions may not always be appropriate, but skilled advisers have the potential to add great value to clients if they know when and how to broach the topic. This value should include a discussion of how investors can potentially improve long-term returns hugely by recognising and correcting the mistakes they make.

The more advisers learn about concepts such game theory, herding and other behavioural biases, the more they can do this. There is so much good science around these topics now that no-one could call behavioural finance a fad. Instead, it will be a key factor driving the adviser-client relationship, as they ultimately develop a rich model of financial decision-making that benefits clients in myriad ways.

Seen a blog, news story or discussion online that you think might interest CISI members? Email
Published: 10 Jan 2022
  • Bonds
  • Financial Planning
  • Risk
  • Fintech
  • Training, Competence and Culture
  • Wealth Management
  • Tobin's Q Ratio
  • Richard Thaler
  • Prisoner's Dilemma
  • Greater Fool Theory
  • gamification
  • GameStop
  • game theory
  • Daniel Kahneman
  • cryptocurrency
  • confirmation bias

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