Behavioural Economics: The Bare Basics
Behavioural Economics is the study of psychologically based factors on the economic decisions of a person or institution and the resulting consequence on the financial market. This includes how public favour drives market decisions. Basically, how we make the decisions on where we choose to save, spend, and invest.
There are three predominant themes behavioural financiers observe when taking behavioural economics: Heuristics, framing, and market inefficiencies.
Heuristics are often subconscious rules an individual applies to a complex problem, usually based on personal experiences and not the entire problem itself. These choices can stray from logic and create cognitive biases. Put incredibly simply, Jane loved a certain type of biscuit as a girl, so when she retired she decided to invest in the company that makes that biscuit. It gives her a sense of nostalgia, but it has no basis in sound investment principles.
Framing is when the outside world as a whole affects an individual’s perspective of reality. It uses generalisations, stereotypes, and interpretations of facts to guide an individual to a conclusion that may or may not be accurate. Framing is also considered a heuristic, but its basis is far more intentional from outside sources. Jane is told by a particular media outlet that she must buy gold now. Not commodities, but actual gold. Jane trusts this media outlet because it is a “news” channel so she begins to sink all her money in actual gold coins – ignoring the reality that the major news conglomerate has very real stakes in the price of gold and wants to drive it up by creating the myth of a shortage or national scare.
Market inefficiencies are anomalies that contradict the Efficient Market Hypothesis (EMH). The EMH grades markets as weak, semi-strong, or strong based on a number of conditions – basically counting on everyone playing by the same rules with all the information available. Calendar effects are an example of this. In January, the securities market tends to rise more than in any other month, encouraging investors to purchase stocks before the year’s end for a short sale at the beginning of the New Year.
Seasons also affect the outcome of the market. Jane will buy natural gas commodities in before the winter, when demand for gas will be higher and sell before spring drives the price down again. A market’s momentum is another type of anomaly. It simply states that stocks that tend to be rising will continue to rise, while those with poor past performance will keep falling. In a strong market, this should not be the case without changes in information, supply, or demand. The phenomena is often attributed to cognitive biases of the traders and investors.
Financial theoreticians seem conflicted with what to do about behavioural economics and its effects on various markets. Some want to devise a way of adjusting regulations to prevent cognitive bias and others believe that point of view is no longer viable in this technological age of social media and networking.
Either way, until they get rid of Jane altogether, behavioural economics is going to be a major factor in the current and near future markets.