HUMANS OFTEN ACT IRRATIONALLY
A systematic approach is needed
Why Behavioral Finance
We humans don’t always act rationally. Throughout the entire decision-making process, we humans make mistakes in our thinking. Beginning with the perception, the processing and up to the evaluation of information. We unconsciously use heuristics (rules of thumb) and are subject to bias.
This can lead to a misjudgment of probabilities, information, objective realities or one’s own ability. Cognitive psychology can be used to explain the occurrence of different heuristics and distortions. The occurrence of systematic price distortions on the capital markets, triggered by emotions and cognitive limitations, is to be regarded as the center of the financial market theory of Behavioral Finance.
A structured, well-considered approach is indispensable for the long-term success of family wealth. It is important to define the appropriate strategy and implement the considered plan in the long term. In this way, the individual heuristics and distortions can be addressed and prevented in the best possible way.
SIMPLIFY OF ISSUE
We reduce perceived complexity by hiding information that is of no obvious or only minor importance to the assessment of a decision. This approach saves our human resources in the perception of information. A good example is the rounds or neglect of slight differences in amounts. The ill-considered use of this tool can lead to non-rational investment decisions.
The human ability to concentrate is not consistently high but decreases over time. As a consequence, the information first transmitted in an information series is perceived more strongly than the subsequent information.This is the so-called primate effect. Subsequent information is thus superimposed in its meaning by the previously transmitted information. The processing of information which has been so influenced results in irrational investment decisions. In addition to the primate effect, people are also subject to the so-called priming effect. This means that information perceived later is influenced by the initial information received. At least as long as they are in the same context.
Selective perception is the phenomenon whereby decision-makers do not take all available information into account in the decision-making process. Instead, information is perceived only selectively. Which information is considered in each case depends on the respective personal ideas, preconceived opinions, needs and expectations. If we have strong expectations, a particularly high amount of new information is needed to change or even refute existing expectations. This can lead, for example, to an investor having high expectations for a particular share, despite clear warning signals.
The availability heuristic describes the effect of giving too much importance to information that is more easily recalled in one’s memory.
Decision-makers consciously access this information. At the same time, less available information is deliberately ignored, neglected and hidden.
The heuristic of mental accounting is a form of complexity reduction during information processing. The term mental accounting stands for the conscious disregard and neglect of mutual dependencies between individual projects, purchase decisions or results. People tend not to mentally store the totality of projects or decisions in the aggregate. Instead, they are mentally stored and managed in separate and isolated accounts. Possible dependencies are not considered. In the context of investment decisions, this means that investments are often isolated and not viewed in the portfolio context.
According to anchoring uristics, people tend to judge new information in information processing on the basis of a benchmark (anchor). The adjustment between two different information is done step by step from anchor towards the true value. There is nothing wrong with the process of step-by-step adjustment, however, numerous empirical studies show that this adjustment process is usually insufficient because the anchor used is given too much weight. This can lead to a distortion of the formation of expectations and misjudgments, for example with regard to share price performance.
In retrospect, we’re all smarter! People tend to judge the likelihood of an event occurring in hindsight differently than they did before the event occurred. In retrospect, it is claimed that the outcome of an event was predicted exactly as it ultimately happened. “I knew it had to happen that way.” This behavior is called Hindsight Bias. People who are subject to this bias tend to regard the observed results as the only possible consequence. The uncertainty associated with the event is often clearly and systematically underestimated, while the possible alternative results are underestimated. This often leads to a false sense of security, which can lead to disadvantageous investment decisions.
The overconfidence bias describes the fact that decision-makers systematically overestimate their own abilities and are therefore overconfident. This can influence and distort the decision maker’s expectations and judgment. Decision-makers overestimate their own level of knowledge and their ability to make decisions independently and correctly. Ultimately, there is excessive confidence in one’s own cognitive abilities. The accuracy of the decision taken is often overestimated compared to a rational and objective view. This leads to an incorrect calibration of expectations and ultimately to distortions in decision making. Furthermore, the risk of loss or the duration of trend phases on the financial markets is regularly underestimated as a result of overconfidence and thus incorrectly assessed.
The human approach of reacting more sensitively to losses than to profits is called loss aversion. For example, it can be empirically observed that losses are weighted more strongly than profits of the same amount. If the comparison of small profits with small losses is made, it can be seen that the losses are assigned a value twice as high. The occurrence of loss aversion can be explained with the help of cognitive dissonance and the human need for freedom from dissonance. Profits are generally perceived as positive by the decision-maker and losses as negative. If a decision leads to a profit, i.e. to a positive result, the desire for freedom from dissonance is fulfilled. However, cognitive dissonance can easily occur if a decision is lost. The justification of the losses against oneself occurs and psychological costs arise. This can lead to investors having a stronger tendency to invest in supposedly safe investments and to shy away from more profitable but fluctuating investments in the long term.
The endowment effect describes the effect by which objects in the personal possession of a person subjectively increase in value. Damage perceived by the abandonment or sale of personal property is perceived as greater than the benefit of buying the same item. The subjectively perceived loss of value due to the abandonment of an object therefore weighs more than the benefit of maintaining it. The endowment effect can be observed very well on the financial markets in the form of another effect. This is referred to as the disposition effect. Investors tend to sell positions that are in profit rather than losing positions. There is a tendency to hold loser shares in their portfolios longer than winning shares. This leads to a reduction in the achievable yield. The sale of a loser position is often seen as an “admission of error”. This is not consistent with a desire for consistent action.