CASE STUDY: Behavioral Finance (Marks 25)

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 its 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 its 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.

Conventional finance believes that our emotions does not interfere with our financial decision making. Discuss this premise with appropriate rationale.