Unraveling Market Behaviour through Behavioural Finance | CFA Level I Portfolio Management

As we wrap up our study on behavioural biases, let’s delve into how behavioural finance influences market behaviour.

Understanding Market Anomalies and Inefficiencies

While the efficient market hypothesis suggests that markets price in risk perfectly, making it impossible to earn abnormal profits, market anomalies and inefficiencies still exist. Some market anomalies, such as the momentum effect, bubbles and crashes, and the outperformance of value stocks over growth stocks, may be influenced by the behavioural biases of individuals.

Momentum Effect: Availability Bias and Hindsight Bias

Studies show that momentum or trending effects, where future price behaviour exhibits a positive correlation with the recent past, can partly be explained by availability bias and hindsight bias.

Availability bias: If an asset’s price rises for a period, investors might extrapolate this rise to the future due to their vivid recollection of recent events.

Hindsight bias: Investors may feel regret for not owning a stock when it performed well in the past and try to remedy this regret by investing in it now.

These behavioural factors can lead to extended stock rallies and contribute to overtrading.

Asset Bubbles and Crashes: Cognitive and Emotional Biases

Asset bubbles and crashes have long been present in trading markets and challenge the concept of market efficiency. Behavioural finance may not fully explain these phenomena, but some cognitive biases and emotional biases can be identified.

During bubbles, investors often exhibit overconfidence, leading to overtrading, underestimation of risk, and lack of diversification. Overconfidence is also linked to hindsight bias and confirmation bias.

Regret aversion may encourage investors to participate in a bubble, fearing they’ll miss out on profit opportunities as asset prices soar.

As a bubble unwinds, some investors may underreact due to anchoring, believing that the price will eventually return to previous highs. Eventually, investors capitulate as the price plunges, further accelerating the decline.

Value Stocks Outperforming Growth Stocks: Halo Effect and Overconfidence

The long-term outperformance of value stocks over growth stocks is another anomaly that may be influenced by behavioural factors.

The halo effect, a form of representativeness bias, may lead to the overvaluation of growth stocks and their long-term underperformance against value stocks. Overconfidence can also play a role in predicting growth rates, potentially leading to overvalued growth stocks.

Investors may also invest heavily in firms they have an emotional attachment to or those that have memorable marketing messages. This is a form of availability bias, and such firms are more likely to be growth stocks with flashier products and higher marketing budgets.

Another anomaly related to the halo effect is home bias, where investors invest heavily in their domestic companies in a global portfolio. This goes against rationality, which suggests greater diversification to reduce portfolio risk.