Phuket Post :: Article :: EXPAT MONEY

Ever since the birth of the first economist, financial students have attempted to bring sense and rationality to the financial markets.

Nobel Prize-winner Harry Markowitz�s seminal �Efficient Market Hypothesis� is arguably the best-known and most complete attempt to shine the light of reason into the murky waters of the equity markets.

Even this hypothesis has failed to fully explain investor activity, and this is where behavioural finance steps in.

An example of how human behaviour affects the markets is the concept of loss aversion.

Loss aversion states that investors feel the pain of losing money more strongly than the joy of making it, and that investors are more likely to take on risk if it has the potential to mitigate losses.

Consider the following options:

1. A coin toss US$100 gain or US$100 loss
2. A coin toss US$10,000 gain or US$100 loss
3. A coin toss US$125 gain or US$100 loss

Most people would refuse to play in Option 1, accept enthusiastically Option 2 and think carefully about Option 3.

If we were rational beings, we would accept any bet where the odds were stacked in our favour; hence US$101 gain or US$100 loss should be accepted.

We are not rational beings.

It is true that if our total assets were US$100 USD, then losing everything we own would be worse for us than the potential benefit of doubling our assets. However, this loss aversion extends into investing in general.

Another example often cited is the so-called �theatre-ticket example�.

Faced with a lost theatre ticket on the way to the show, most people would not buy a replacement [Hmm, not so sure about �most people�. Anyway, what about sunk cost error? Ed.]

However, if the money to buy the ticket were lost, most people would head straight to the nearest cash machine.

This demonstrates how we judge objects with similar cash values with different emotional values.

Behavioural finance is used to explain why people invest their money conservatively and then buy lottery tickets.

Simply, investors are able to treat events separately, using a different set of values for each decision. Investors have a number of mental �jam jars�.

For example, the lottery ticket purchase is justified in the investor�s mind as the stake money comes from an entirely different mental �jam jar� to their savings.

Another aspect to behavioural finance is that of psychological barriers seen in indexes and currencies. Examples would be the US$/GBP rate of 2.0, the DOW at 13,000 and the AUD/USD at 0.8.

However �uneconomic� it seems, there is a lot of evidence suggesting that these markets move differently around these barriers than they would do away from them.

How do we use behavioural finance? Well, understanding how you are affected is the first step.

Ask yourself, have you bought a stock at a certain price, which subsequently dropped? Are you waiting for that stock to move back up to your buy price before selling? Do you know � deep down � that your money could be better invested elsewhere?

If so, consider yourself a victim of your own bad behaviour.