Learning outcome F4c of the Financial Management (FM) syllabus is as follows: Describe the significance of investor speculation and the explanations of investor decisions offered by behavioural finance.
The learning outcome is at intellectual level 1, meaning that knowledge and comprehension of this topic is required.
This article briefly looks at what behavioural finance is and some important terms related to behavioural finance which students should know.
What is behavioural finance?
Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences. This is in contrast to many traditional theories which assume investors make rational decisions.
Important terms to understand
One aspect to understand is the market paradox. This occurs because in order for markets to be efficient, investors have to believe that they are inefficient. This is because if investors believe markets are efficient, there would be no point in actively trading shares –which would mean that markets would not react efficiently to new information.
Herding refers to when investors buy or sell shares in a company or sector because many other investors have already done so. Explanations for investors following a herd instinct include social conformity, the desire not to act differently from others. Following a herd instinct may also be due to individual investors lacking the confidence to make their own judgements, believing that a large group of other investors cannot be wrong.
If many investors follow a herd instinct to buy shares in a certain sector. This can result in significant price rises for shares in that sector and lead to a stock market bubble.
There is also evidence to suggest that stock market ‘professionals’ often do not base their decisions on rational analysis. Studies have shown that there are traders in stock markets who do not base their decisions on fundamental analysis of company performance and prospects. They are known as noise traders. Characteristics associated with noise traders include making poorly timed decisions and following trends.
Some investors may have loss aversion, avoiding investments that have the risk of making losses, even though expected value analysis suggests that, in the long-term, they will make significant capital gains. Investors with loss aversion may also prefer to invest in companies that look likely to make stable, but low, profits, rather than companies that may make higher profits in some years but possibly losses in others.
There may be a momentum effect in stock markets. A period of rising share prices may result in a general feeling of optimism that prices will continue to rise and an increased willingness to invest in companies that show prospects for growth. If a momentum effect exists, then it is likely to lengthen periods of stock market boom or bust.
Behavioural finance shows that individuals may not necessarily make decisions on the basis of a rational analysis of all the information. This can lead to movements away from a fair price for an individual company’s shares, and the market as a whole to a period where share prices are collectively very high or low.
An in-depth understanding of all the different behavioural biases and potential impacts of behavioural finance is not required at this level, but the terms and concepts covered in this article may appear in an FM exam question.
Written by a member of the Financial Management examining team