Do investors always follow the rules of rational financial investment?

The most important assumption at the base of the standard of traditional theory of finance is about the rationality of the representative investor, the so-called Homo Economicus. This average investor is supposed to have unlimited ability to process the available information and preferences, which are perfectly described by the expected utility theory. To keep it simple, she is supposed to have an unbiased decision-making process following the rules of rational investing, with no regard for the psychological context in which it is framed. As a consequence, the researchers were led to develop a class of mathematical models describing the behaviour of the representative investor, whose main drivers are

the following: returns, their probability distribution, and their combination with the standard microeconomic theory of utility. The fundamental assumption of rational unbiased behaviour also led researchers to make two statements. Number one, markets are efficient, which means, according to Professor Fama, that it is impossible to consistently outperform the overall market. Or to put it simply, that changes in asset prices are unforecastable. Number two, that prices reflect fundamental values of assets. Even if the investor’s behaviour were actually biassed, they said, it would be unable to affect overall market efficiency because those biases are unlikely to be systematic. And because eventually, in the long run the biassed investors would be washed out of the market by the rational ones.

Looking for the empirical evidence about the foundations of the standard theory of finance, though, many violations of their main assumptions were found. For instance, some patterns and seasonality were found in the asset prices showing elements of statistical predictability. When tested in long run, market reaction to corporate news seems not to be as efficient as it is in the short run. Psychological biases and cognitive errors were found to be among the drivers of important financial decisions, such as those about pension funds participation, asset allocation, and trading. For instance, investors are proven to be loss rather than risk averse, meaning that gain and losses of the same amount affect the investment decision process in a different way.

Investors also show a tendency to sell assets whose price is rising and keep those whose price is falling. That is the so-called disposition effect. They trade too much. That’s overconfidence. And they use heuristics, rules of thumb, rather than a correct probabilistic representation of the event space. Financial decision makers also tend to invest too much in their home assets - that is the home bias, and to have a misperception of the probability distribution after a success, the so-called hot-hand fallacy. The list could go on indefinitely, but given all this, a question arises. Do investors always follow the key rules of rational financial investment?

The behavioural revolution led by Kahneman and Tversky in 1979 has tried to give an answer, starting with the claim that the Homo Economicus assumption should be questioned. There is no representative investor as the deviations from the average behaviour are too important in affecting the decision process to be neglected.

Today there is an astonishing and growing amount of research in behavioural finance. But it is possible to pinpoint several key themes and applications at its cutting edge.

Heuristics: researchers are trying to identify and understand how mental shortcuts may affect financial decision-making in terms of easing the cognitive load it requires.

Framing: different ways of framing the same question can lead to different behaviours by the same individual. In this field, the research had pointed out how investors provide different forecasts when asked to think about prices and returns of assets. Pension decisions are different when framed in a different way, and so on.

Market impact: does psychology play a role in explaining market anomalies? Are asset prices fair? Can we really rely on the Efficient Market Hypothesis to build mathematical models of investors’ behaviour? These are some of the questions researchers try to answer when dealing with the market impact of behavioural finance. Now, besides knowing and understanding biases, a large part of the research in behavioural finance is now focusing on two questions. Is it possible to learn how to make individually and collectively better decisions? And how? These questions have given birth to a new strand of research studying how biases can be overcome and focused on three key areas. Number one, individual context.

Analysing how investors personal characteristics can provide a decision-making framework able to help them take decisions in their own best interest. A typical example are decisions regarding retirement, which should be framed taking into account an ageing investor, her cognitive decline, and how peer effects drive choices.

Regulatory framework, focusing on how regulators can provide well-designed policies in order to overcome those biases not addressed privately, and avoid the potential negative spillovers. And then we have education, promoting awareness and the study of the decision processes as the first step towards an effective decision-making. Even though much work has been done in behavioural finance, much more is still needed in order to definitely answer to the question of whether the investors always follow the key rules of rational investing. We are far away from clearly understanding how people make their financial choices. But the pace is growing, together with the importance of the matter, thus inspiring confidence for the future.