Sunday, June 26, 2016

BREXIT surprise, behavioral bias, and uncertainty

Investors make mistakes. They will have biases. These biases may have contributed to the market sell-off on Friday. I am looking at the reasons for why the financial community was so wrong about BREXIT. The tight poll number suggest that hedging or reducing risk exposure would have been a prudent strategy, yet the negative market reaction was swift and large and in the opposite direction of the markets from the previous few days.The markets were caught by surprise.

I believe in part  there were some behavioral bias at work. For Londoners in the finance community, there was a bias from agreeing with all those around you who have the same opinion. The areas outside London are like different regions. The finance community has an information asymmetry because they are not in touch with those outside of the city. If they in fact acknowledge that there is a different opinion, there is the view that it is obviously wrong. 

If everyone around you agrees with your thinking, you may fall for the idea that your circle of friends represents the greater view, a false consensus. This is consistent with an in-group bias where we want to believe the views of those in our tribe or circle. Granted the polls showed a close vote, but the bias for many was thinking that this could never occur given their group or home base is thinking this would be such a bad idea. 

Researchers have found a "home bias" with portfolio allocations. One of the explanations for the home bias is that there is information immobility or asymmetry. Even if capital is mobile, if there are large information differences or views across names, there will be less diversification. Investors will not change when there circle of information or opinions is consistent with their current allocations. They will anchor with the things they know. When the surprise comes, it will be big. 

Of course, this was an event that was uncertain and could not have been properly handicapped in spite of the all of the polls. There may not be a behavior bias with being wrong on a highly uncertain event. The complexity of the issue made any judgment on how citizens would vote ambiguous. Unfortunately, if investors were truly facing an uncertain event, holding cash or hedging would have been the trade before the event. So why was the market positioned differently?

Many managers are going to require some deep introspection on how they positioned themselves for this trade.

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