Because we are not homo economicus

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Although investors should be nothing but logical, they often ignore the fundamentals and go astray while investing. We interviewed behavioural scientist Nicola Gennaioli to understand why investors fall into the trap of emotions and how to avoid them when making financial decisions.Every investor seeks pretty much the same things - good investments and value that can earn profits. Fairly simple and logical, right? Yet, markets don’t seem to always act logically, and we often see strong emotions driving stock movements.

Although cognitive biases came into the spotlight only during the early 1960s, economists have been concerned about the bounds of rationality in an individual’s decision-making process way before that. And, thus, neo-classical economists had to come up with the concept of Homo Economicus to reinstate discipline as a natural science, where everyone behaves rationally. However, we know that the ground realities are far from it.

Behavioural economist and co-author of A Crisis of Beliefs, Investor Psychology and Financial Fragility, Dr Nicola Gennaioli explains how behavioural fallacies act as a roadblock in an investor’s decision-making prowess, and how one can overcome them.

Could you tell us how you see investors go astray and overlook the fundamentals of investing because of behavioural fallacies?

One of the key ways in which behavioural fallacies manifest themselves is expectation formation. For my book, co-authored with Andrei Shleifer, we ran surveys on several investors and analysts and got evidence that the expectations of many market participants look extrapolative - too optimistic after good news and too pessimistic after bad news. The results of these experiments showed that this pattern in expectation errors is central to understanding bubbles, financial crises, including the 2007-2008 one, and also the micro-investment mistakes that one makes at an individual level.   

What are most common behavioural fallacies that investors can fall prey to?

Overreaction is a strong and well-known fallacy. It is pervasive not only in the stock markets but also in the bond markets. Saying that, overreaction does not mean that we should be mechanically contrarian. Simply buying stocks whose prices have gone down does not make for a good investment strategy.

It is not easy to go contrarian when the markets are going mad about a hot stock. Like behavioural fallacies make you a bad investor, can behavioural economics rescue you and help you become a good investor as well?

Yes, of course. In particular, to exploit overreaction, you should look at the data and target patterns that are indicative of genuine overreaction. In our experiments, we discuss one such pattern that is based on expectations. Looking at the survey results of expectations, we found that one could spot with greater precision companies about which the market is too excited and also companies about which the market is too pessimistic. Once you spot these overreactions, one can make wiser investment decisions.    

Should behavioural strategies change, depending on the type of investor one is?

Yes, definitely. For instance, taking advantage of certain instances of overreaction sometimes means shorting smaller stocks, which entails some liquidity risk that not all investors are willing to take. But in our data analysis, there appears to be a benefit also in going long on larger undervalued stocks, albeit a smaller one. The latter may suit better a more conservative investor.

Can discipline be a solution to stop falling prey to behavioural fallacies?

Absolutely. Discipline is crucial, especially in trying to avoid overtrading and in market downturns, where one should avoid pulling out too quickly. However, being disciplined, especially over extremely long periods of time, isn’t an easy task. The trick here is to avoid following market movements on a daily basis and rather have a long-term view and reassess your position accordingly.

Behavioural economics doesn’t believe in market forecasts and predictions. So, as a behavioural scientist, what is your advice to investors? What are the fundamental principles that they should base their decision-making on?

Be very sceptical! Sceptical of any intuitive judgment made on the fly, on the basis of casual observation, unsystematic data or attention-grabbing narratives. To the extent possible, consult good research in behavioural finance which identifies more reliable methods for spotting anomalies, for instance, on the basis of expectations data. Remember that sticking to fundamentals is the key to being more rational.

 


  

About the interviewee: Nicola Gennaioli studies topics in the behavioural economics and finance. He has published several papers in the leading international journals and most recent publications can be found in Quarterly Journal of Economics, The Journal of Finance and The Princeton University Press.

He obtained a PhD in economics from Harvard University in 2004. Before joining Bocconi in 2012, he held research positions at CREI (2007-2011), Stockholm University (2004-2007), and a postdoc position at Harvard (2009-2010). He is currently a Research Professor at the Barcelona Graduate School of Economics (BGSE).