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Why humans are not made to become successful investors.

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The prevailing theory of capital markets is based on the assumption that all individuals display rational behaviour. It is assumed that the maximisation of benefit is at the centre of the action for all actors. So decisions are always made on the basis of a complete assessment; with all available information. So much for theory. The following article describes how market participants actually act: They tend to make mistakes when perceiving, remembering, thinking and judging - systematically and often unconsciously. Find out what consequences these cognitive distortions have for performance and what options there are for taking action against these performance killers.

Behavioral Finance = Economy + Psychology

This is a relatively new branch of Behavioral Finance, which links economics with psychology.  The psychologist Amos Tversky laid the foundations for behavioral capital market research with Daniel Kahneman, who later won the Nobel Prize in Economics. The scientists made behavioral patterns transparent that had previously been ignored by the advocates of rational decision-making. These behavioural patterns arise because logical thinking - especially in situations of uncertainty - is often overlaid and overridden by feelings. It is therefore worth taking a close look behind the scenes on human behaviour, not only for scientists, but especially for investors and traders.

Why man stands in his own way

Among the most important causes of irrational behaviour are - besides the brain architecture itself - psychological motives. On the one hand, people want to keep their own situation and that of their immediate environment, to the best of their ability, under control. Why do human beings have a need for control? The theory of the control motive assumes that every human being has the need to perceive himself as the cause of changes in his environment, or more precisely: a need to be convinced that he has control over his environment and his actions. This creates a feeling of competence and self-esteem, which leads to an increase in self-esteem. A loss of control, on the other hand, can have serious negative effects on well-being.

A classic example:

Many traders, but also analysts, want to predict future price developments with all their might, instead of simply following the respective market and adjusting quickly if necessary. After all, the frantic search for the perfect entry and exit is impossible - and not even necessary to make money in the markets.  

In order to satisfy this need for control, it is necessary to resolve so-called cognitive dissonances that can arise after a decision has been made. These occur when a person realises that a decision taken was unfavourable. If this is the case, the dissonance can be reduced in two ways. Either the decision is revised - in the rational variant - or one "corrects" one's attitude by means of selective perception in such a way that the decision no longer appears to contradict reality. For example, investors tend to play down bad news about a stock they have in their portfolio, while overweighting positive information.

Cognitive dissonance

After almost all decisions where there was a choice between several alternatives, people get into a dichotomy. This arises when the alternative the person could have chosen has negative characteristics and the discarded option also has positive characteristics. This state causes an unpleasant feeling and is called cognitive dissonance in psychology. The theory of dissonance states that every person tries to eliminate inconsistencies in perception and thinking as quickly as possible, because they trigger an unpleasant feeling. The greater the cognitive dissonance, the stronger the urge to reduce it. If there is a strong emotional bond between the decision-maker and the decision itself (high commitment), it may even become impossible to reverse the decision.

Simplify and judge quickly - Heuristics

People who are involved in the stock market often face the difficult task of drawing the right conclusions from the mass of information in a short time. Behavioral Finance therefore deals intensively with the application of rules of thumb, the so-called heuristics. This is an automatic mechanism that is used to reduce complexity and to make quick - but often not optimal - judgements. This can be done both consciously and unconsciously. The most important heuristics are described below.

Mental accounting

Mental accounting refers to the habit of people neglecting to account for the possible interdependence between the individual engagements and projects in question. People therefore do not have the totality of all projects and their effects in mind, but keep several separate, so-called "mental" accounts. If, for example, the commitment in Share A and Share B (assumption: shares have no correlation) is valued in isolation from each other, the investor could decide not to invest because of the high risk of the two individual shares. In doing so, he or she naturally overlooks the diversification effect and misses out on potential profit opportunities.

Mental accounting

Case A: Mr. Mustermann has purchased a theatre ticket for the price of 100 Euro. When he arrives in front of the theatre, he finds that he has lost the ticket. Tickets of the same price range are still available at the box office. Will Mr Mustermann buy a new ticket?
Case B: Mr. Mustermann has reserved a theatre ticket at the box office. When he arrives in front of the theatre, he finds that he has lost 100 euros from his wallet. Will he buy the ticket if he still has enough money with him? From an economic point of view, both cases are identical. Empirical studies show, however, that the majority of those questioned in case A refrain from going to the theatre, in case B they redeem the reserved ticket. This example shows that by keeping two separate accounts ("theatre account" and "cash account"), the decision behaviour in an economically identical situation can be different.

How experience and random numbers influence us

Availability heuristics are also used to reduce the complexity of an issue. For example, an investor who has already experienced a stock market crash considers the probability of a price collapse to be much higher than an investor who has not yet had such experience. In order to arrive at a quick judgement, the "anchor effect" is often used. This describes the tendency of people to link their assessments to - often arbitrary and therefore incorrect - reference values in their memory. This happens particularly when certain information cannot be immediately classified and evaluated. In price forecasts, "round" price levels, highs or lows or the current level usually serve as anchors. Orientation to an arbitrary - and thus wrong - reference point prevents a neutral valuation and therefore often leads to wrong decisions. The anchor effect can also be observed in daily shopping: Here the manufacturer's recommended retail price, which is usually undercut by the respective dealer, serves as an anchor for the prospective buyer.

Anchor effect

In one experiment, test persons were asked how high they estimate the percentage share of African states in the United Nations. For this purpose they were divided into several groups.
Before answering the question, each group was presented with a random number between 0 and 100. Subsequently, the test persons had to indicate whether their estimate was above or below the random number.
In a further step, the participants of the experiment were asked for the concrete number.

Here it was shown that the number randomly determined by the wheel of fortune had a clear effect on the result: In the group where the random number was 10, the answer was 25%. The other group, in which the random number 65 was determined, came to a significantly higher value of 45%.

Connections that do not exist

Another phenomenon for quick judgement is the so-called representativity heuristic. Representativity can be explained most easily with the term "scheme". Every person has a multitude of schemes in his or her head, which he or she has acquired through experience or through learning. Test persons who are supposed to judge which sequence of coin tosses is more probable - KKKK or KZZK (K=head, Z=number) - usually consider the latter constellation as more probable. Statistically, however, these are independent events and the probability for both scenarios is 0.5 4 =6.25%.

Since the human brain is designed to recognize patterns intuitively, the thinking system often leads us astray.

It can be observed that people overestimate the probabilities of representative events. Likewise, empirical and causal relationships are often overestimated or even seen when none exist. The latter can be associated with the need for control described above. On balance, it can be seen that the use of heuristics often leads to misjudgements and non-optimal decisions.

Yield killer number one: the disposition effect

In addition to the heuristics listed, the fact that people always evaluate on a relative basis plays a major role within Behavioral Finance and thus explains numerous behavioral anomalies. For example, studies show that most people would rather live in an environment where they had 100,000 euros and the average population only 50,000 euros, than in an environment where they had 200,000 euros and everyone else had even more, namely 300,000 euros. The relative perception and valuation also leaves a clear mark on investor behaviour. Every investor has experienced at some time or another that he or she has sold too early stocks that have recorded high price gains over the years, and still owns those that have floundered from low to low. Even experienced investors fall into the same trap again and again. Why is that?

Science explains this behaviour as follows: For the investor, the entry price acts as a reference point and thus defines the profit and loss zone. If the price falls below the entry price, the reason why it is so difficult to sell the security is that profits and losses are not felt to be equally strong. Losses weigh more heavily than profits. So we are more annoyed about a loss of X Euro than we are happy about a profit of X Euro. Initial price gains provide joy for the investor, but the intensity of the positive feeling increases only disproportionately with the further increase in book profits. In the event of temporary setbacks, the tendency to take profits - usually too early - therefore increases significantly. In the area of losses, the decreasing sensitivity initially shows the same effect: anger about the first euro loss is at its highest and then decreases more and more. This has fatal consequences, because with each further slide into the loss zone the factor hope gains in importance - usually with a negative outcome.

disposition effect
Figure 1: Disposition effect
According to Kahneman and Tversky losses are felt about twice as strongly as gains. This asymmetric risk aversion means that investors tend to sell positions that are in the profit zone too early and hold loss-making positions for too long.
Source: Kahneman, D., Tversky, A. "Prospect Theory: An Analysis of Decision under Risk" (1979)
Premature profit-taking and the tendency to hold on to loss positions for too long are due to the disposition effect.

Totally irrational: The Reflection Effect

A highly irrational form of behavior resulting from the decreasing sensitivity to changes in value is the reflection effect. Thus, with regard to risky alternatives, it can be observed that decision-makers behave in exactly the opposite way in the transition from profits to losses and thus behave in a highly irrational manner. The example on the right should illustrate this in detail.


The following alternatives are available:
Case A: Secure profit of EUR 1 000
Case B: Profit of EUR 2 000 with 50 % probability

The majority votes for A and is therefore risk-averse. If the test is repeated with the opposite sign - there is a choice of a EUR 1,000 safe loss or a EUR 2,000 loss with 50% probability - the test persons become surprisingly risk aware and choose the latter alternative. The reason: the uncertain loss is subjectively rated less negatively than the certain loss of EUR 1 000.

Afterwards everyone is smarter!

After the most important "rationality traps" have been presented, the question of feasibility in practice arises. Especially on the stock market, it is evident that classic mistakes are made again and again. But the so-called retrospective effect (hindsight bias) can also be observed in everyday life. If you ask an investor, analyst or scientist today, for example, whether he or she foresaw the dotcom crash or the financial crisis, the answer will very often be affirmed with a nod of the head - even if the assessment at the time was completely wrong. What is the reason for this? Nobody likes to admit when they were wrong. The danger of this tendency lies above all in overestimation. Those who believe that they have predicted many things correctly in the past will wrongly assume the same from the future. A learning effect cannot therefore occur.

Outwit yourself!

Behavioral Finance shows that the behavior of market participants is anything but completely rational. Emotions and experiences play a major role. The rationality traps - e.g. the use of heuristics, relative evaluation and the pursuit of freedom from dissonance - are in clear contrast to the theory of homo-economicus and make it clear that only the combination of financial and social science can contribute to a better understanding of the financial markets. The individual investor can also benefit from the findings, because those who recognise typical behavioural errors in themselves can improve their own decisions. At the same time, one can exploit the inefficiencies caused by the misconduct of others. The contrarian approach, i.e. "swimming against the current", is rewarded on the capital market with an above-average return when extreme moods such as greed and panic are observed. The stock market development during the recent corona crash and the subsequent rally is an excellent example of this. On balance, the more neutral and rational basis on which a decision is taken, the better - even if we have to accept the fact that we will probably never act completely rationally in financial matters either.

The following tips should help investors and traders to improve their performance in the long term:

Concentrate on the essential information and analyse it very carefully.
News that seems to be quick and easy to grasp is also easily available to others. The danger that these have already been incorporated into prices is therefore high.
If you have an opinion on a particular market or security, try to find people who have a contrary view. Market participants who agree with your analyses often have the same position as you do and are therefore anything but neutral.
Don't be distracted by "cheap propaganda", but make your own decision.
Ensure that your investments are sufficiently diversified.
Proceed in a disciplined manner. Set yourself buy and sell targets even before the transaction. Good trade planning provides valuable services in this respect.
Keep an eye on the big picture instead of reacting to every piece of news that is available.
Avoid decisions that are based on panic or euphoria.
Recognize your own mistakes and see them as an opportunity to learn from them.
Who recognise typical behavioural errors in themselves can improve their own decisions. At the same time, one can exploit the inefficiencies caused by the misconduct of others.

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