Traditional finance is fundamentally based on the idea that investors are assumed to be rational decision makers. This in turn would make financial markets efficient and that market prices fully reflect all available information. However, empirical studies show that investors and markets behave differently.
Behavioural finance attempts to explain some exceptions to market efficiency. This perspective challenges the pillars of traditional finance by suggesting that investors are subject to cognitive and emotional limitations, known as biases. Cognitive biases capture how investment decisions are taken with faulty reasoning, for example how information is processed and memory errors. Meanwhile, emotional biases explain how market behaviour is influenced by investors’ feelings at the time an investment decision is taken. This bias reflects impulse and intuition.
What is market momentum?
Market momentum is exhibited when recent market returns are expected to persist for a period of time, typically in the short term. On the upside, momentum is observed when good performing securities continue to increase in price. Meanwhile, securities which are out of favour tend to remain supressed. This creates a trending effect.
Momentum can be partly explained by several behavioural biases.
One of the most common observed tendencies is herding investment behaviour. This type of behaviour occurs when investors follow what others are doing and find comfort in investing in the same assets as others. Rather than supporting investment decisions from a fundamental point of view, investors choose to align with consensus opinion. As a result, investors continue to invest on one side of the trade.
Another example is the confirmation bias, which is a cognitive error due to belief perseverance. This represents how investors tend to continue to maintain a belief by ignoring new information which contradicts it, while looking for information that confirms with their belief.
The availability bias is also a cognitive bias that explains how investors assess the probability of an event to occur by how easily the outcome is recalled. In this context, this bias creates a recency effect. Given that recent events are more easily remembered, investors tend to give undue importance to latest events. If a price of an asset rises for a period of time, investors tend to expect that asset to continue to perform.
Investors are also subject to emotional biases which create a trend chasing effect. Regret aversion is a product of hindsight bias. This bias reflects how investors tend to view past events as predictable. In other words, this contributes to market momentum since investors tend to buy assets which have recently performed positively and wish to have owned in the past.
Despite being a supporter of a fundamental approach to investing, one has to appreciate that financial markets are a product of investment decisions taken by individual investors. From a behavioural finance perspective, market momentum can be partly explained by behavioural biases observed among investors. As a result, momentum is likely to impact the investment performance.
This article was issued by Rachel Meilak, Equity Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.