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From the Dutch Tulips Mania to the panic of 2008...

Behavioural finance attempts to study and explain the economic behaviour of individuals participating on the market, as well as their irrational character.

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Contrary to classic financial theory which puts forward the hypothesis that economic players are rational and that market prices adjust in function of the evolution of fundamental factors, behavioural theory suggests that a certain number of biases are susceptible to influencing prices. These biases can be cognitive, for example related to the way in which our brain treats information: in this way, when we are convinced of the direction of the market, our brain will have a natural tendency to overshadow or refute all information that contradicts our beliefs. It could be related to a natural aversion to losing, which could prevent one from selling a security in strong decline (“not sold, not lost!”) or worse, to strengthen one?s position in the decline, in the hope of “recovering.” These biases can be emotional (hope, pride, panic, euphoria...) ; individual or collective (for example related to crowd psychology...) ; and can even go as far as influencing the fundamentals (the case of the self-fulfilling prophecy!)

The implications in terms of risk for the investor are important : Even if one supposes that it is possible for the individual to free oneself from their own behavioural biases, the market itself can remain distant from the fundamentals during (sometimes long) periods: as Keynes - who knew a thing or two about it - pointed out : “the market can stay irrational longer than you can stay solvent.

But is behavioural finance a new phenomenon? Not really. Mainly thanks to information technology, the markets of today do not have much in common with those of our parents and grandparents; human character seems to remain a constant, though sometimes irrational. In effect, behavioural intuition finds many examples in economic history, well before they were made formal by the Kahneman and Tversky Nobel prize during the 1970?s. Signs of this can be found in the Charles McKay?s 1840 classic, Extraordinary Popular Delusions and the Madness of Crowds. Already a century prior, Sir Isaac Newton, on the subject of the bubble of the South Sea Company, declared that “it could calculate the motions of heavenly bodies, but not the madness of people”. As for Jesse Livermore, legendary trader who became famous during the crises of 1907 and 1929, he formulated the hypothesis that “throughout time, the investor has had to fight against hordes of enemies that cost him a lot of money, and which are hidden in the depths of himself : ignorance, greed, fear and hope, which are inherent to human nature.”.

From the Dutch Tulips Mania at the beginning of the XVIIth century to the the panic of 2008, trends and investment themes come and go; the errors of investors? behavior stay the same...

Emmanuel Regnier September 2009

Article also available in : English EN | français FR

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