Talking Heads – Using behavioural insights for better investment decisions

This is an edited transcript of the audio recording of this Talking heads podcast

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing behavioural finance. I’m Daniel Morris, Chief Market Strategist, and I’m joined by my colleague Aquiles Mosca, who, as it happens, is a teacher of behavioural finance. Thanks for joining me.

Aquiles Mosca: Thank you.

DM: What exactly is behavioural finance, and how can it be used to improve investment decisions?

AM: Traditional economic theory has one main assumption regarding the behaviour of investors or economic agents, which is that we are all rational. That means we use all the public and private information available to make the best decisions, which leads to the conclusion that markets are efficient.

What behavioural finance is about – based on research by Daniel Kahneman in the early 1980s – is the fact that not all the decisions we take are fully rational. While there is no evidence of irrationality, it appears more realistic to work with an assumption of limited rationality.

The limitation in rationality comes from a series of behavioural trends. Most of these are unconscious, innate. Some are hard-wired through evolution and it’s very hard to resist them. Behavioural finance proposes that we work with the assumption of limited rationality, that we need to understand where this limitation comes from and use that to take better decisions.

DM: With these modified assumptions, can behavioural finance help us better understand the dynamics of complex market movements and trends?

AM: This is the field of applied behavioural finance, and the answer is ‘yes’. If we take the extreme example of speculative bubbles or market crashes, this is directly related to understanding the dynamics of herd behaviour.

There is a lot of literature covering the factors behind the creation of herd behaviour, be it in a bull market creating a bubble or a bear market creating a crash. We know we like to act in sync with other people. We feel good, we like to fit in. This is the first element of herd behaviour.

The second is what Stanley Milgram, a University of Chicago psychologist, called the social consensus. He experimented by having one guy staring at the clouds at Lake Michigan. Only 5% of people stopped to see what he was looking at. Then he had 20 people looking at the clouds and 80% of passers-by stopped to look, too. This is the concept of social consensus. The greater the number of people doing something, the more we think there is a good reason for that.

The third element of herd behaviour is that if things go wrong, we don’t like to be alone. The herd gives a sense of protection.

The last element is the fear of missing out. We don’t want to be left behind. We want to be together. Even if things go wrong, at least we are not alone. These are well-mapped behavioural trends that form and sustain herd movements that may create a bubble in a bull market or a crash in a bear market. Behavioural finance can help explain, comprehend and hopefully avoid the unwanted consequences such movements may cause.

DM: Are there examples of behavioural biases that help us make better investment decisions?

AM: A very common notion of behavioural biases is that they are all negative. That was from early behavioural finance when it was said that 90% of behavioural biases may compromise a good professional or personal investment decision.

More recently, some academics have been working on how to use those same biases to protect investors. In 2021, one paper from a group of Indian and German researchers showed that we can use two behavioural biases – the endowment effect and the IKEA effect – to help investors.

An example of the endowment effect would be that if I need to sell something I own, I have a tendency to try to charge a lot. So, if I have a car worth 100 000, then simply because it’s mine and I take care of it, I want 105 000 for it. We put an premium on it because it’s ours. This is the endowment effect, which happens frequently, especially with real estate.

The IKEA effect is derived from the endowment effect. When we put our energy and time into developing something like IKEA furniture that you have to assemble yourself, you tend to add extra value to that.

The researchers looked to use this to benefit investors. They compared people who only execute an investment recommendation with those who work with their investment advisors in the construction of their portfolios.

The people who were more involved with building their portfolios tend to maintain a moderate risk portfolio. When a downturn comes, they do not reduce their riskier asset positions by as much as the others – they keep a more diversified portfolio for a long time, and they had better risk-adjusted returns over horizons of between one and three years.

DM: Thank you very much for joining me.

AM: Thanks for having me.

This presentation includes a discussion on current market events and is not intended as investment advice or an offer of products or services by BNP Paribas Asset Management. Please keep in mind that the information and analysis in this presentation is only current as of the publication date.