January 24, 2013

Times Change, Investors Don’t

The fears, concerns and reactions common in your clients today have a historical precedent

As impossible as it is for investors today to imagine the stock market in the 17th century, it would have been equally impossible, if not more so, for investors back then to have the remotest inkling of the technological wonder that is the modern day stock market.

However, while the markets have radically changed through the ages, investor behavior really hasn’t changed at all, says Teresa Corzo, finance professor at the Universidad Pontificia Comillas in Madrid—and chances are it isn’t likely to change in times to come.

Corzo—part of a recently minted research group at the Universidad Pontificia that focuses on behavioral finance—bases her argument on 17th century Spanish merchant, philanthropist and writer Jose de la Vega’s “Confusion de Confusiones” (“Confusion of Confusions”), a book published in 1688 that many believe to be the first description of the workings of a stock market (Amsterdam’s, in this case, since that’s where de la Vega lived) and the behavior of those who participated in that market.

The book discusses, among other thing, how the volatility of the stock market can cause changes in the behavior of buyers and sellers, as well as the speculative aspects of trading stocks. De la Vega attributes this not only to the diverse, individual abilities of the actors, but also to a range of external influences.

Corzo and her colleagues came across the tome at a special exhibit on classic financial books at the Madrid stock exchange.

“While reading through it, behavioral finance kept coming to our minds,” Corzo says. “We decided to read it very carefully [from that perspective], and not only did it have amusing depictions of investors in the 17th century, it also described the same behaviors that are being studied today in the area of behavioral finance.”

Overconfidence, regret, loss aversion, a natural tendency to follow the herd: These behavioral traits were as prevalent in the 17th century investors de la Vega observed as they are in investors today, Corzo says. Although the market at the time was not even a fraction of what it is today, de la Vega still observed such traits as excessive trading, overreaction, underreaction and the disposition effect, where investors are more likely to quickly sell winning stocks but hold on to losers.

“The book shows us that investor behavior has not changed with technological and scientific advances. It continues to be the same,” Corzo says. “No matter the time, the country, the place, their age or their gender, human beings have always had the same basic instincts that guide them in their decisions, and this will not change with the times.”

This is what makes behavioral finance even more important today as an area of study and focus for financial advisors. Given that the human mind has not changed since the 17th century and the same instincts seem to guide investment behavior, it’s all the more important to understand those instincts that condition behavioral patterns, Corzo says, because the predictability of investor behavior has great implications for investing and for the financial markets.

Although behavioral finance has gained far more traction in these past years, Corzo believes that the notion of efficient market forces and the rational human mind still guide the financial industry to a far greater extent that human emotion and impulse do.

Of course, not all investors are guided by feelings and biases, Corzo says, and many do take their financial decisions in a more rational, rules-based manner.

However, “financial markets would be better understood if there’s a good mix of behavioral and rational methodologies,” she says.

Although investors today have an enormous array of tools and technology that can help them make better and more rational financial decisions, human beliefs and basic reactions to different situations and contexts have always been conditioned by the mind and always will be.  

Knowing that the human mind has not changed very much when it comes to financial behavior, that the same sorts of impulses guide investment decisions, can help advisors work with clients within the context of those behaviors and, rather than seeking to change or ignore them, accept them and work with them, Corzo says.

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