The importance of taking human behavior into account when dealing in finance has been increasingly acknowledged over the past few years. An understanding of traditional and behavioral finance theories can not only help you to better predict market movements, it can also allow you to avoid some of the more common mistakes made by traders.
A brief introduction to financial theories
Most theories approaching decision making from a traditional finance perspective have their roots at the beginning of the 20th century, and speculative activity was first analyses by John Maynard Keynes in 1930 and John Hicks in 1939, in their early studies on future markets. In 1952, Harry Markowitz concentrated his efforts to define a theory to optimist the trade-off between risk and return. His optimal portfolio selection theory indicated portfolio diversification as a means to minimise risk.
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His findings were further developed by James Tobin in his 1958 two fund separation theorem, and then reformulated by William Sharpe in 1964 and John Lintner in 1965, in their Capital Asset Pricing Model theory (which included risk and returns logic).
These models are still in use by portfolio managers as a theoretical framework to allocate investments and balance risk against performance.
The major drawback of these theories is their assumption of investor rationality and focus on paradigms belonging to traditional finance. Behavioural finance academics believe that traditional models give only limited explanation about why investors trade or how a portfolio of investments is built, and place too much emphasis on risk and return as the only motivators involved in the investment decision process.
Instead, Behavioral finance maintains that investors are not fully rational and that the information available on a certain asset is, for many reasons, not fully reflected in its stock price. Psychological studies into behavioral finance have uncovered investment decision imperfections, market inefficiencies and behavioural biases belonging to human nature.
This alternative way of approaching finance is of particular interest for investors using CFD trading and spread betting to approach financial markets. Would it be equally easy for you to implement and commit to your investment strategy when trading on a demo account and a real account, where your own funds are put at stake?
The investment decision process involves considerations belonging to the fields of both finance and psychology. Focusing only on one of these two fields would only give a partial scenario of a broader phenomenon. For instance, many economic models are based on a number of assumptions which lie outside real-world scenarios (e.g. the efficient market hypothesis and the Capital Asset Pricing Model).
Also, an investor’s decision making process is not perfectly rational because of behavioral tendency distortions: emotion, risk-aversion, acquired psychological patterns, information asymmetries and intuitions are just a few characteristics that will de-rationalise a decision. These aspects deserve extra attention, especially when it comes to trading on CFDs and spread betting, where risk and reward can be amplified.
CFDs and spread bets are leveraged products and can be used with success to take advantage of fast moving markets. But some investors find it hard to stick to their trading strategy and, especially in the long run, some tend to approach the market without a clear idea in their mind.
More information on CFDs is available here: http://www.ig.com/uk/cfd-trading
The extant literature on behavioral finance is vast and can be overwhelming, so here are a few particularly relevant examples of some of the most common mistakes made when trading CFDs and spread betting. The rationale behind this selection has mainly emerged from analysis of CFDs and spread betting characteristics as opposed to traditional share buying, as well as my experience as a financial dealer.
Loss aversion: opening riskier positions to amend previous losses
A 2005 study by Joshua Coval and Tyler Shumway provides evidence of behavioral biases for proprietary traders of the Chicago Board of Trade. Because of loss aversion, these traders tended to open riskier positions in the late trade session if they incurred losses earlier in the day.
In his renowned manual for stock brokers, Leroy Gross states that this practice ‘has probably wrought more destruction on investment portfolios than anything else’. Loss aversion causes traders to persist on the same path and raise the stakes in the hope to break even soon: but when investment decisions are driven purely by the desire for immediate recovery from running or realized losses it becomes easy to take the wrong decision. This is something worth considering, especially when dealing on leveraged products.
Overconfidence, the anchoring bias and underestimating risks
Overconfidence has been broadly studied by theorists in behavioral finance such as Richard Thaler and Daniel Kahneman. Overconfidence in their own judgements causes traders to anchor to initial investment decisions even when they are clearly wrong. Underestimating risks and sticking to wrong choices are common misconceptions, and believing that ‘in the end the market will move back’ could negatively affect the performance of your portfolio.
To me, this seems to be especially true of male CFD traders and spread betters. I get the impression that female traders are more keen to study and research before getting into the market and less prone to overconfidence than their male counterparts.
When facing a negative position which is unlikely to recover, the best approach is usually to accept being wrong, realize the loss and move on with the next trade.
Mental accounting and the house-money effect
How are your investment decisions affected by prior gains or losses? Thaler and Johnson investigated the house-money effect for the first time in 1990, defining it as increased risk-taking following a gain. Their study shows that under some circumstances, a prior profit can increase a trader’s disposition to take gambles.
Imagine you take a chance on the Forex market and buy a couple of EUR/USD contracts just before the non-farm payrolls report release. The market then moves swiftly in your favor and you make a profit of £1000 in few seconds.
How will this influence your trading behavior for the rest of the day? Many individuals will consider money coming from an easy profit differently to money coming from their bank account. This is, of course, a clear behavioral bias: £1000 is £1000, regardless how or how long it took you to get it.
Behavioral biases such as the ones described so far broadly apply to CFD traders and spread betters. I hope that reading this brief article and understanding a bit more on some common mistakes will help you to approach the financial market with more confidence. It would add greatly to my satisfaction if I succeeded in conveying even a small part of my enthusiasm for this subject to you with this piece.