Our last few articles have focused on behavioural finance and influences on risk perception. It is important because the notion of perception implies that there is a subjective or qualitative component that affects risk management decisions in spite of (and sometimes in place of) quantitative analysis. In this article, we will be looking at how overreaction causes winners to become losers and how Availability Heuristics can explain this.
A study conducted by behavioural finance academics, De Bondt and Thaler, revealed that after an initial loss, a portfolio of the top 35 losing stocks rebounded to beat the market index. Conversely, a portfolio of 35 initially winning stocks ultimately underperformed against the market. They explained that investors overreacted to bad news and drove prices down. Upon realising that their pessimism was unfounded, losers began to rebound as positions were oversold. The opposite was also true for initial winning positions as overreaction caused them to be overbought.
Availability Heuristics explains that people typically have a rule of thumb (heuristic) that causes them to judge a risk as highly probable if examples of it are easy to remember or visualize. This implies risk decisions are heavily biased towards information that is:
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- Induced strong emotions
- Intensely dramatic
In the Context of Forex
In the case of De Bondt and Thaler’s research, we can explain that investors are affected by Availability Heuristics, making hasty investment decisions biased towards recent, dramatic financial news that evoke strong emotional reactions. In their rush to act on this information, they drive up or down the prices of assets, causing them to be overbought or sold.
Consider the SNB debacle. When the SNB announced that it would unpeg the CHF from the EUR, the franc soared dramatically. With this information in hand, USD/CHF traders also unloaded their dollars for francs rapidly.
However, there was no founding for this reaction. Where the EUR has been floundering because of the ongoing European Debt Crisis, the US economy has been strengthening, and with it the USD. Most would agree that the selling off of USD against CHF was an overreaction, which was turned around when investors realised that Availability Heuristics had got the better of them. Almost 3 months on, we can see how the USD/CHF has steadily risen back from its sudden and dramatic drop, whereas the EUR/CHF hovers near parity and is yet to recover due to the ongoing crisis.