Behavioral finance, a subfield of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source for the explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price.
Concepts:
Herd behavior
Herd behavior refers to the tendency for individuals to follow others’ financial decisions, instead of doing their own research and analysis. For example, if a person notices others are investing in a certain stock, it may motivate them to do the same. To avoid herd behavior, individuals could do their own research to make financial decisions and measure their risk. Historically, herd behavior can start large sell-offs and market rallies in the stock market.
Mental accounting
Mental accounting is the tendency for individuals to save and allocate money for specific purposes. Based on subjective criteria, this could cause individuals to place different values on the same amount of money. Because people classify funds differently, this may cause irrational or irregular financial activity, such as finding a low-return savings account while carrying large credit card debt. To compensate for mental accounting, many finance professionals encourage their clients to recognize this bias and assign equal value to equal sums of assets.
Emotional gap
An emotional gap describes when an extreme emotion motivates an individual’s financial decisions. In finance, the emotions that often comprise an emotional gap are anxiety, greed, enthusiasm and fear. These are the key reasons people make irrational decisions. Fear and greed can harm portfolios, affecting the stability of the stock market and the economy. Finance professionals often strive to advise individuals against these trends, offering long-term plans based on firm fundamentals and rational advice.
Anchoring
Anchoring is based on the fact a benchmark price has a disproportionately high influence on an individual’s decision-making. For example, if a professional sees a certain stock costs $100, they may use that purchase price as a reference for how much the stock’s actually worth. Anchoring can cause them to stay fixated on that number, ignore other indicators of value and adjust their beliefs and actions accordingly.
The individual may assume the market price is the correct price, which can make them base new decisions on old information. This may result in selling an overachieving stock while keeping an underachieving one and taking the losses.
Self-attribution
Self-attribution is the tendency for someone to make decisions based on an overestimation of their skill. This can mean someone considers their knowledge above the level of other professionals. This bias could lead to incorrect decision-making because it doesn’t factor in outside influences and expertise. People can avoid self-attribution by listening to the advice of financial professionals and researching the possible outcomes of a decision before committing to it.
Assumptions:
- Investors truly care about utilitarian characteristics.
- Both the market and investors are perfectly rational.
- Investors have perfect self-control.
- They are not confused by cognitive errors or information processing errors.
Traits of behavioral finance are:
- They actually have limits to their self-control.
- Investors are treated as “normal” not “rational”.
- Investors are influenced by their own biases.
- Investors make cognitive errors that can lead to wrong decisions.
Biases:
- Confirmation bias: Paying close attention to information that confirms a finance or investment belief and ignoring any information that contradicts it.
- Self-attribution bias: Believing that good investment outcomes are the result of skill, and undesirable results are caused by bad luck.
- Representative bias: Believing that two things or events are more closely correlated than they really are.
- Framing bias: Reacting to a particular finance opportunity based on how it is presented.
- Loss aversion: Trying to avoid a loss more than on recognizing investment gains, so that desirable investment or finance opportunities are missed.
- Anchoring bias: Letting the first price or number encountered unduly influence your opinion.
Advantages:
Creates Predictable Patterns: People who study behavioral finance know that people behave in certain predictable patterns. This is because they are driven by emotions.
For instance, if the sentiment prevailing in the market is that of fear, then more people are likely to sell their stock. Similarly, once the price reaches a certain threshold, there is somewhat of a rebound. Behavioral investors often use charting techniques and conduct a technical analysis to identify patterns. Once they see the patterns repeating, they are able to capitalize on them and make more money.
Explains Asset Bubbles: Traditional financial theories have been unable to explain the concept of asset bubbles. If all market participants are rational, then why do markets behave irrationally for a long period of time? How is it that sometimes people end up providing companies with a higher valuation than the entire industry.
Creates Buy and Sell Opportunities: If an investor has not understood the behavioral aspects of finance, they too are likely to blindly follow the trend. This means that they are likely to sell when the markets are crashing and buy when they are booming. Investors with knowledge of behavioral finance are able to segregate the truly catastrophic events from overreactions in the market. As a result, knowledge of behavioral finance helps investors identify buying and selling opportunities in the market. The knowledge of these biases helps them to manage their emotions and think clearly, which ultimately ends up creating more wealth.
Helps Understand the Concept of Time Horizon: Students of behavioral finance understand that investors behave differently based on the stage of life that they are in. A young person who has several years of investing left is likely to take more risks. On the other hand, older people are more likely to sell as soon as they see a price drop.
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