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Home > Rationally understanding market irrationality
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Rationally understanding market irrationality
07 Dec 2020
In these uncertain times, proficiency can bring clarity to people concerned about today’s undecided markets. A crucial ethos in investments is to separate emotions from investing and make better financial decisions by avoiding behavioural or cognitive bias. Understanding the concept of behavioural finance can help avoid emotional actions which can lead to hurried decisions, likely losses and managing investments better during volatile periods.

Behavioural finance comes about as a way to explain, in a rational way, the irrational behaviour of markets and investors or, as one acclaimed economist portrayed, finance from a broader social science perspective including psychology and sociology (Miller, 2019). 

On the other hand, traditional financial theory holds that markets and investors are rational; investors have perfect self-control and are not confused by cognitive errors or information processing errors. Evidently enough, this is rarely the case since it is very difficult to limit self-control and emotions.  Fear and greed can have a tremendous impact on trading patterns from the behavioural finance aspect. Such emotions can lead to panic buying, confirmation bias, memory bias, framing, crowding, overconfidence, fear-of-missing-out (FOMO) and fire sale. But all these biases make us human beings, who are emotional, irrational and who invest in stock markets based on our beliefs.

When observing market movement fluctuations, divergences between the financial markets and the economy can be apparent. Such variances usually widen and are more prominent throughout extreme and volatile periods. Case in point is the current COVID-19 pandemic, which left the market in shocks, recoveries and a great deal of market instability and uncertainties. So why did the market experience a ‘U’ or ‘V’-shaped recovery and at whiles, indices recorded all-time high figures, if the economic outlook was not so promising? Many factors can drive investors to pursue investments during such times, which may be mainly attributed to Central Bank stimuli, high liquidity levels, market trends and valuation of assets.

Nowadays, asset managers are taking behavioural components of investing seriously, and with good reason. According to behavioural finance, the majority of trading mistakes are made due to emotions. This makes fear and greed the main risk factors in any trading strategy. In that sense, robots are better emotionless traders. However, the shortcoming of robo-trading strategies is their inability to factor in and capture all market trends, emotions, fears, beliefs, macro understanding and risk management.

The decision making process needs to be based on fundamentals, investment objectives, and risk and reward expectations. Decisions which are based on emotion and not on logic, or common sense, lead to panic and speculations.

Behavioural finance works to cover the rationality; in order to make good financial decisions, people need to stay rational. The trickiest part of putting your money into a bearish bet is the timing. You can be right that a market or sector is overvalued but wrong on the timing. That’s essentially what economist John Maynard Keynes means when saying, “The market can stay irrational longer than you can stay solvent.”

This article was written by Robert Grech and published on the Sunday Times of Malta on 6th December 2020. Robert Grech is a Portfolio Manager at BOV Wealth Management. He is a qualified Financial Analyst and has been employed with Bank of Valletta for the past 12 years.


This article is not, and nothing in it should be construed as a recommendation in respect of investment products or services offered by the BOV Group.  Any views, assumptions or opinions expressed in this article are those of the author. Value of investments may go down as well as up and may be affected by changes in currency exchange rates. Past performance is not a guide to future performance. Issued by Bank of Valletta p.l.c., 58, Triq San Żakkarija, il-Belt Valletta VLT 1130.  Bank of Valletta p.l.c. is a public limited company regulated by the MFSA, licensed to carry out the business of banking and investment services in terms of the Banking and Investment Services Acts (Cap.370, 371 of the Laws of Malta).  
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