This Is Your Brain on Finance

Today, investors are drowning in data. As a result, more people are resorting to the ease of intuition for a shortcut. It’s easy to see why the idea of intuition is attractive. We’re all familiar with the fun movie cliché of a detective strolling passed the police line while narrating a detailed account of a crime without any preparation. Intuition is appealing. Unfortunately, it’s also wrong most of the time.

"Behavioral finance" is a branch of psychological theory, which explores the flaws of using intuition in decisions about money. We’re all subject to these pitfalls because they’re inherent in our DNA. While scientists can identify such flaws, it's unlikely that we'll ever escape them. However, if we can’t avoid irrationality can we at least account for it when forecasting the market? Researchers writing for International Trade, Economics, and Finance explain why we can.

The authors of the paper “Effect of Behavioral Finance on Gold Price Trend” explore the idea that financial markets might not be as efficient as we once thought. When a market is "efficient," it immediately responds to changes in the fundamental value of its components. That is, all stock and commodity prices always reflect all relevant information. For example, factors like consumer behavior, international economies, and quarterly earning reports all move the market as soon as they change.

There is, however, an unseen force influencing markets and you won’t find it on a balance sheet. “Financial assets appear as uncorrelated with their fundamentals,” explain the authors.

This phenomenon is evident in the gold market. The researchers aimed to factor in human psychology to more accurately predict gold price trends. Instead of relying purely on economic factors like supply and demand they include a “behavioral component for a better representation of markets reality,” to explain the “observed discrepancy between actual and expectable commodity value.”

Here’s what they found:

Several biases are in play among those investing in the market. One example cited in the paper is the “Anchoring Bias.” This term describes our tendency to rely too heavily on the first piece of information we encounter. Subsequent information, therefore, has less influence in decision-making. The researchers hypothesize that “investors under-react to analysts’ predictions.”

Meanwhile, as investors ignore such predictions, they often place too much emphasis on the prevailing mood of the market. This tendency, the “Safe Value Bias,” is characterized by the fact that “gold demand significantly correlates with markets instability.” Historically, gold has offered a low correlation to most other asset classes. Therefore, when market sentiment becomes fearful, investors turn to gold. While gold can have a stabilizing effect on a portfolio, purchasing the commodity based on short-term outlook is a flawed decision. Instead, gold should be considered a long-term investment that yields value year over year. Too often short-term purchases are driven my shortsighted thinking.

The researchers remind us that cognitive biases are ever-present when investing. Many of us can become more rational investors if we occasionally ask ourselves how emotional impulses influence our choices.