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Case Study - Behavioral Finance

This document discusses behavioral finance and how irrational decisions by investors can lead to market corrections. It uses the example of worries over a Portuguese bank sparking fears of financial contagion in Europe and a sell-off in the U.S. stock market, despite Portugal accounting for an insignificant portion of the global economy. While timing corrections is impossible, the investment committee sees opportunities to profit from the emotional biases and panic of other investors during irrational market movements.

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Yashi Srivastava
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912 views5 pages

Case Study - Behavioral Finance

This document discusses behavioral finance and how irrational decisions by investors can lead to market corrections. It uses the example of worries over a Portuguese bank sparking fears of financial contagion in Europe and a sell-off in the U.S. stock market, despite Portugal accounting for an insignificant portion of the global economy. While timing corrections is impossible, the investment committee sees opportunities to profit from the emotional biases and panic of other investors during irrational market movements.

Uploaded by

Yashi Srivastava
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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A Case Study In Behavioral Finance

We Are All Human


Behavioral Finance is a field of study that combines psychology, economics, and finance to
offer an explanation for why investors make irrational financial decisions. Our emotions are
powerful forces that often override logical conclusions, and this struggle typically leads to
suboptimal results.

Traditional finance theory assumes all investors to be rational, a highly unrealistic scenario,
so it’s critical for an investor to have a basic understanding of the emotional traps that exist
in markets. Not only will spotting these traps protect your portfolio over the long run, but you
will also get better at recognizing when others have become ensnarled, which are some of
the best times to seek profit.

NOTE: All market participants are prone to emotional forces in their investment making
decisions, which is why it’s so important to have an investment team consisting of diverse
opinions and skillsets. Our Investment Committee is a great example of such a team
because we operate as a “checks and balances” system for portfolio design, buy/sell
decisions, and asset allocation.

Here are just a few examples of the biases, or traps, that investors must avoid in order to
reduce risk:

 Conservatism Bias: Maintaining a prior forecast by inadequately incorporating new


information. An example would be an investor that is so sure of his reason to buy a
stock that he then completely disregards new information that contradicts or even
disproves his thesis.
 Confirmation Bias: Looking for data that only confirm a belief and ignoring the data
that contradict or even disprove this belief. Human nature tends to put more weight
on what we believe versus what we do not.

 Loss Aversion Bias: When an investor strongly prefers avoiding losses as opposed
to achieving gains. This behavior is the primary reason why so many investors will
hold their losers even if an investment has little or no chance of going back up.

 Self Control Bias: When one fails to act in the best interest of long-term goals due
to a lack of self discipline. For example, an individual who spends money now
instead of saving for retirement. This bias will often cause an investor to take on too
much risk for the satisfaction of short-term returns vs. lower risk to achieving the
long-term goal of financial freedom.

These biases explain some of the greatest market euphoria (dot-com boom) and bubble
bursts (financial crisis) in recorded history. They have existed for thousands of years and
they will exist for thousands more to come.

Can Portugal Really Cause a Correction?


Worries over the financial health of a Portuguese bank spooked global markets on
Thursday, sending global markets down including the S&P 500. The catalyst for the concern
stemmed from a missed payment on short-term debt issued by the country’s second largest
lender, which then sparked fears over a possible contagion in the European financial sector.
The Investment Committee struggles to see how a single bank in Portugal can cause billions
of dollars in equity value to simply disappear. To explain why, let’s first look at the charts
below which offer a visual representation of just how irrelevant Portugal is to the global
economy:
Portugal accounts for 0.14% of the global market, which is roughly 1/10th the size of Italy.
Furthermore, this chart represents the entire economy of Portugal so imagine the impact of
one bank here is to the overall global economy (keep in mind that this bank did not fail or go
out of business).

Furthermore, fears over contagion appear to be extremely low given that the rest of Europe
is far more financially secure than Portugal, and the European Central Bank (ECB) has
explicitly stated that they will not allow the Eurozone to fail.

Despite this evidence and the positive U.S. economic data released over the last two weeks,
investors panicked and sold stocks here because many feared over the beginning of a
broad correction in U.S. equities.

NOTE: A correction is defined as a 10% or greater decline in an equity index. Currently we


have not experienced a correction in the S&P 500 since 2011, and many market pundits
have spent the last six months predicting a correction solely because one has not happened
in a longer than normal time period.

This panic selling in the S&P 500 is a classic example of confirmation bias. In the face of a
rising economy, an unemployment rate not seen this low since before the financial crisis,
and robust consumption from consumers and businesses alike, the bears simply scoured
the headlines until they found data that could loosely support their theory.

Implications for Investors


Here’s where behavioral finance can be frustrating and profitable at the same time. Although
the data show that Portugal is practically irrelevant, we still admit that it could ignite a
correction. Timing these events is impossible and there’s been so much media time
dedicated to the subject that we could very well talk ourselves into one as bears point to
anything even remotely supportive of a selloff. This is the part that can be frustrating
because corrections are not always rational.

However, the Investment Committee enjoys nothing more than to profit from the fear and
panic of others, and we welcome any major market correction due to concerns over a single
missed payment at a bank that continues to operate in a country that comprises 0.14% of
the global economy. This is the part where behavioral finance can be profitable!
The bottom line is that we may not be able to predict emotionally driven corrections, but we
do stand to profit when they occur because our team is highly skilled at recognizing when
these biases are driving irrational behavior in markets.

This commentary is not intended as investment advice or an investment recommendation. It


is solely the opinion of our investment managers at the time of writing. Nothing in the
commentary should be construed as a solicitation to buy or sell securities. Past performance
is no indication of future performance. Liquid securities, such as those held within DIAS
portfolios, can fall in value. Global Financial Private Capital is an SEC Registered
Investment Adviser.

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