Behavioural finance offers path to market recovery.

Investors could be willing to take on more risk to recoup their losses.

Behavioural finance theories are gaining prominence and could plausibly explain the wild market volatility of recent months, according to Jan Mahrt-Smith, an associate professor of finance at the University of Toronto’s Rotman School of Management.

Speaking at the University of Toronto on Tuesday, Mahrt-Smith pointed out that behavioural finance has recently gained much more attention as financial experts and commentators seek to explain the dramatic market activity of recent months.

“Behavioural finance is everywhere these days,” said Mahrt-Smith, who is also co-director of the Rotman Master of Finance Program.

One of the roles of behavioural finance, which is the study of non-rational decision-making and the ways such decisions impact financial markets, is to fill in the gaps of rational finance theories, Mahrt-Smith explained. For instance, behavioural finance acknowledges that investors have different expectations about investments, and that changes in investor confidence levels can impact the markets. In addition, the theory shows that emotions can play a role in investing.

Certain irrational investment behaviours could have played a role in adding to the market volatility of recent months. For instance, Mahrt-Smith pointed to studies showing that investors tend to focus more on gains and losses than their overall level of wealth.

“It should be only wealth matters,” he said. “But it turns out we care about gaining money or losing money much more.”

Whether a loss is big or small, it can have a significant impact on a person’s happiness, he added.

“One dollar gain is a gain, it’s fantastic. One dollar loss is a loss and it’s horrible,” Mahrt-Smith said.

The losses incurred by investors early in the downturn, therefore, could have helped trigger an irrational panicked reaction that led to a more severe selloff and added momentum to the downturn.

Some of the investment losses of recent months could also have been worsened by the tendency for investors to hold on to losing stocks longer than winning stocks -- a reality of investment behaviour, according to Mahrt-Smith.

“We’re willing to gamble that it will come back up, but we don’t want to take the loss,” he said.

He added that the recent crash could change investors’ behaviour going forward.

“We’re all poorer now, so we have to recalibrate how we think going forward,” he said. “Maybe using historical statistics isn’t going to be the same when you’re going through a period of a crash or a bubble.”

In particular, Mahrt-Smith said that even though nearly all investors have lost money in recent months, behavioural finance theory shows that they could be willing to take on more risk to recoup their losses.

“We’re going to behave quite differently from these risk-averse, rational investors,” he said. “People are going to gamble for a resurrection.”

Mahrt-Smith noted that there are some considerable arguments against using behavioural finance theories to explain the current market events. For instance, some argue that since all investors tend to behave differently, it is difficult to draw generalized conclusions about this behaviour.

Still, Mahrt-Smith said the theories represent a promising starting point for justifying some of the ways investor behaviour has played into the widespread market volatility of recent months.

(-Courtesy of: "Investment Executive - 03/18/09 Article by Megan Harman.)