Insights from Square Mile Investment Services

Behavioural Finance – Why some battered beans might hold the answer

I was reading an article the other day by Warren Buffet, one of the greatest investors of our generation. He said “most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well”.

This so called investment ‘guru’ got me thinking. Why is the stock market so different from every other market? If you went into a supermarket and a tin of baked beans was half the price it was a month earlier, you are far more likely to buy it now than a month ago.

This would apply even if the reason it was half price was that it had a dent in it and it looked a bit battered. After all, the beans would still taste the same!

‘most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well’

The reverse happens in the stock market. If a stocks price falls 50% because it’s taken a bit of a battering like our proverbial tin of bins, you immediately think that something is wrong with it and there is less chance of you buying it than when it was twice the price a month ago and looking all shiny. Fundamentally, like our tin of beans, it’s still the same stock.

This brings me to Behavioural Finance. Over the last few years, an increasing number of market commentators have talked of this as a new way to invest but what does Behavioural Finance really mean?

Since the late 1970’s a number of academics have put forward theories that have developed the idea that stock prices can be overly influenced by human behaviour as opposed to fundamentals.

This has led to the development of the theory of behavioural economics, or behavioural finance. Ever since the Dutch Tulip bubble in 1630 there have been numerous stock market bubbles and crashes, the most recent of which we can all too well remember when the Global Financial Crisis happened in 2008/9.

These bubbles and subsequent crashes led the academics to observe that, despite the advances in technology and availability of information, investors continue to make the same, or similar, mistakes. Rather than being cold, rational decision makers, investors are often driven by human behaviours and emotions.

The human brain has evolved over thousands of years to cope with the changing environment but there are moments when it is frightened or overstimulated when the prehistoric part of the brain takes over and the rational logic required to make investment decisions is overridden.

‘Rather than being cold, rational decision makers, investors are often driven by human behaviours and emotions’

Quite often you are unaware that it has happened, but the brain subconsciously ignores what it perceives to be unnecessary inputs and relies on a handful of inputs it recognises or feels comfortable with.

This can lead to investors having overconfidence in their decision making process, anchoring on preconceptions rather than evaluating the full picture before making a decision or indeed just following the herd through fear of missing out. This is probably why the stock prices tend to go up the escalator but down the lift!

The smart investor knows that this leads to opportunities for those who are able to override their emotions and avoid being sucked in by hype from other market participants by focusing on the fundamentals of the companies they are looking to invest in.

It is also important to be able to re-evaluate those fundamentals as the news flow surrounding them changes and not let historic and possible irrelevant information cloud the decision making process.

Put far more simply, don’t be frightened of buying the battered tin of beans just because others are avoiding it. Fundamentally they are still the same beans and will taste just as good!

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