(Guest Contribution from CBA’s Finance Club)
Daniel Kahneman, known for his Nobel Prize winning work on behavioral economics and finance, stated “that organizations should think of decisions like any other product and apply quality controls.” Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effects on the market.
Emotions affect our decisions whether we like it or not. You can look at it this way; organizations are a factory that produces decisions among other things, and thinking about decisions as a product is useful in aiding in the decision making process. Therefore, when thinking of decisions as a “product” the issue of quality control is immediately raised, this is an efficient means of assuring that the decisions being made don’t weaken an organizations financial structure.
MONEY! Is an important commodity that dictates how most if not all organizations operate.
The way people interact with money is amazing, even people who deny that money will not change how they act, allow money to influence their interactions with other people. When money is involved, especially in the business environment, a lot of noticeable actions occur. However, three actions in particular have been brought to my attention, which are Inter-Temporal consumption, Momentum investing, and Herd behavior. Inter-temporal consumption thrives to explain people’s preferences in relation to consumption and saving over the course of their life. Simply put, what this concept states is that people mentally divide their assets into mental accounts – current assets, current income, and future income – and the propensity to over consume or save depends on the earnings they get, along with the depreciation or appreciation of their assets. Momentum investing is a system of buying stocks or other securities that have high returns over a period of 3-12 months, and selling those that have had poor returns over the same period. It has been reported that this method of investment actually yields an average returns of 1% per month. The fact still remains that some economists hypothesize that this phenomenon could be explained by the simple “the higher the risk the higher the return” concept. However, this method actually leads to the inefficient pricing of a stock because of herd behavior, which allows some investors to use the tool of arbitrage. Herd behavior describes how individuals in a group can act together without planned direction or intention. This term relates the behavior of animals in herds, flocks, or schools to the conduct of humans during activities such as stock market bubbles and crashes. Large stock market trends often begin and end with periods of frenzied buying (bubbles) and selling (crashes), these are clear examples of herding behavior that is irrationally driven by emotions such as greed during stock market bubbles and fear during stock market crashes.
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Interesting post, I’ve always been fascinated with behavioral finance!
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yes it is quite a hot topic in finance these days!
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If you like behavioral finance, you should check out James Montiers research reports.
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Saud Reply:
July 31st, 2010 at 3:45 pm
Can I find them online?
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ASJ Reply:
July 31st, 2010 at 3:54 pm
I think if you search for him on google filtering only pdf docs, you probablly can find his pieces when he worked at SocGen and Dresdner Kleinwort. He now works at GMO. If not, just send me your email and I’ll forward them. BTW, he’s written books on the subject, but they’re basically all his research when he worked for these investment banks.
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