26 May Frankfurt Notes – Behavioural Finance: starting points for the practical IR work
The homo economicus of neoclassical economic theory is a consistently reasonable contemporary who maximises his utility with unlimited rationality, irrepressible willpower and without a hint of altruism. Loosely based on the German economist Hanno Beck, a meeting in the flesh is as realistic as that of the elective half-Vulcan Mr. Spock, who landed on Earth after a successful space mission as a self-confident, emotionless consumer and decision-maker.
The Spock of economics has earned enormous merit. What test tubes and laboratories are in many scientific disciplines, assumptions and models are in economics. And these require one thing above all: a representation of reality reduced to essential interrelationships. Many insights would not have emerged without homo economicus. Mission accomplished – or in Spock’s words, simply “fascinating”.
But Mr. Spock and Captain Kirk’s team are fiction. And homo economicus also only exists in the model world. The limits of the concept come to light when it comes to real decisions. Many studies and experiments show that human decision-making processes are complex and do not follow a strict rationality. The economist Richard Thaler puts this in a nutshell with the term “misbehaving”: people do not behave in a way that conforms to the model, their actual decision-making behaviour is multi-layered: we are all no Spocks – to the chagrin of some economists and probably most “Trekkies”.
Behavioural economics starts at this point. The discipline, which is no longer quite so young, focuses on the question of how people make decisions and integrates psychological aspects into the economic sciences. Behavioural finance is specifically dedicated to the issues of the capital market. In the meantime, the discipline has become an integral part of university curricula. Two of its representatives, Daniel Kahneman (2002) and Richard Thaler (2017), have won Nobel Prizes. The topic is known to the general public through bestselling non-fiction books and a wide range of introductory literature for investors and decision-makers.
But where investors can fall back on full bookshelves, capital market communication experts are faced with empty shelves. So is investor relations simply not a topic – or rather an unjustified blind spot? If we take the DIRK definition, “investor relations (IR) […] is the strategic management task of establishing and maintaining the company’s relationships with existing and potential providers of equity and debt capital as well as with capital market intermediaries”. So it’s about understanding investors, markets and also anticipating behaviour. It is about developing intuition and at the same time recognising its limits. And in the dialogue with decision-makers in the companies, it is sometimes also about better founded arguments than referring to one’s own gut feeling.
If one shares the assessment that decision-makers and investors are first and foremost people and not Spocks, a first essential conclusion for investor relations work emerges: where markets are not efficient per se and behavioural economic aspects play a role, it is not only whether but also how information is conveyed that is decisive. Preparation, presentation and interpretation are essential. Simply publishing information “somehow” on the reporting date is not enough. IR managers will not be surprised to learn that: Investor relations matters – also scientifically derivable.
Seven starting points for IR work
But what does this mean for the practical work of IR managers? What concrete conclusions can be drawn? A first approach in seven points:
Keep dividends stable. With the Prospect Theory value function, Daniel Kahneman and Amos Tversky map the subjective value of changes in wealth. Losses are given a higher weight in experiments than gains of the same amount – symmetrical bets in which candidates can win or lose the same amount with 50% probability are not attractive. Meaning for companies? Investors attach value to the stability of earnings and dividend series. Positive surprises against a benchmark cannot compensate for the pain of equal losses in other years. In case of doubt, predictability and reliability are more important than a slightly higher total dividend or slightly higher growth over a multi-year period. Dividend declines must be avoided if at all possible.
Attractive communication offer to private shareholders. Anyone who invests in shares knows how difficult it is to close a position at a loss. Realising a loss means admitting to having been wrong. This is also so difficult because the consequences of different actions are often considered individually, in the sense of so-called mental accounting. This, in combination with the asymmetrical perception of profits and losses, leads to the disposition effect: winning shares tend to be sold too early, while losing shares are held too long. Private shareholders, who usually invest less rule-oriented than institutional investors, therefore form a particularly loyal shareholder group that can lend stability to a share especially in difficult times. The “price” that private shareholders demand for this service: low-threshold information offers via the IR webpage and social media, communication at eye level analogous to other shareholder groups, a reliable distribution policy.
Representation counts. The finger-pointing at the less rule-oriented private shareholder should not be misunderstood. We all make countless decisions every day, important and unimportant, short- and long-term oriented – even the sell-side analyst who covers 15 stocks or the institutional investor who has to keep a continuous eye on 100 stocks. In order to cope with the flood of decisions, we rely in many cases – and often unconsciously – on our intuition. Daniel Kahneman coined the term intuitive system 1 for a fast, automatic, quasi-effortless decision-making process that allows us to reach a judgement quickly. In contrast, rational system 2 stands for a slow, assumption-questioning process that requires time and effort. If the share performance or profit series, which develops volatilely upwards, is presented once as a line chart and once as a column chart via rates of change, most observers do not recognise this – but consider the performance in the line chart to be more convincing. Representations in column and line charts therefore make a big difference in volatile time series. And more fundamentally: It makes a lot of sense to think about and examine alternative representations. This is especially true when certain habits of presentation have crept in that have not been questioned for a long time.
Relying on the IKEA effect. Overconfidence refers to the observable phenomenon of assessing one’s own skills and the results of one’s own actions too positively – whether driving a car or predicting the future. A friendlier way of putting it is to classify it as the IKEA effect. Those who have built the PAX wardrobe or the Excel model of company Y themselves may not only find them particularly successful, but also know very well where parts or assumptions are complete and where they fit together well or not at all. This results in a higher credibility of goals and forecasts: make them calculable.
Setting the right frame.The term framing has found its way into everyday language. Its meaning: The presentation and context of an issue have an influence on its perception. This perception ranges from banal everyday contexts, such as whether the glass is half-full or half-empty or whether whole milk has 3.8% fat content or is 96.2% fat-free, to complex explanatory patterns for economic developments. For example, in “Narrative Economics”, economist Robert J. Shiller defines an economic narrative as “an infectious story that has the potential to change the process of economic decision-making by people”. The investor whose company has made significant investments in future profits is likely to be reluctant to forego their realisation despite other investment opportunities. This is no different from the buyer of theatre tickets who is reluctant to forego the performance despite the attractive party invitation that fluttered in at short notice.
Do not let good things fall by the wayside. The confirmation bias refers to the tendency to perceive information selectively and as confirmation of preconceived assessments. For the sell-side analyst, it is quite rational to hold on to an opinion for longer and to be perceived with it over time. The investor cannot and does not want to constantly rotate his portfolio simply because of trading costs. Positive aspects are also part of the presentation of the situation in a crisis. They can help to keep supporters of the investment case in good spirits – as long as no distortions of reality are created.
Don’t turn a problem into a bottomless pit. Kahneman’s WYSIATI rule (for “what you see is all there is”) is the starting point of the focusing illusion. We all tend to fix developments on the determinants that we ourselves have in view. Complex problems often only become comprehensible through this trick. The opportunity for companies: Narrowing down a problem to its core, combined with clear targets for its solution and a transparent development path, can help to regain trust quickly.
Conclusion: Behavioural finance has great potential to support investor relations managers in their important task of nurturing relationships with investors and constructively presenting corporate reality. Without question, there is still much to discover and do – or in the words of Spock and Kirk: “Full speed ahead.”