What is behavioral finance?
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, especially market anomalies in the stock market, such as severe rises or falls in stock price. As behavioral finance is integral to investing, the Securities and Exchange Commission has staff specifically focused on behavioral finance.
Understanding Behavioral Finance
Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one area of finance where psychological behaviors are often assumed to influence market outcomes and returns, but there are also many different angles for observation. The purpose of the classification of behavioral finance is to help understand why people make confident financial choices and how those choices can affect markets.
Within behavioral finance, it is assumed that financial participants are not perfectly rational and self-controlled but rather psychologically influential with somewhat normal and self-controlling tendencies. Financial decision-making often relies on the investor’s mental and physical health. As an investor’s overall health improves or worsens, their mental state often changes. This impacts their decision-making and rationality towards all real-world problems, including finance-related ones.
One of the critical aspects of behavioral finance studies is the influence of biases. Biases can occur for a variety of reasons. Biases can usually be classified into one of five key concepts. Understanding and classifying different behavioral finance biases can be very important when narrowing in on the study or analysis of industry or sector outcomes and results.
Behavioral Finance Concepts
Behavioral finance typically encompasses five main concepts:
- Mental accounting: Mental accounting refers to the propensity of people to allocate money for specific purposes.
- Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs.
- Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Often, emotions are a crucial reason people do not make rational choices.
- Anchoring: Anchoring refers to attaching a spending level to a specific reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities.
- Self-attribution refers to a tendency to make choices based on overconfidence in one’s knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals rank their knowledge higher than others, even when it objectively falls short.
Some Biases Revealed by Behavioral Finance
Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis. Some of these include:
Confirmation Bias
Confirmation bias is when investors are biased toward accepting information that confirms their already-held belief in an investment. If information surfaces, investors accept it readily to confirm that they’re correct about their investment decision—even if the information is flawed.
Experiential Bias
An experiential bias occurs when investors’ memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as recency bias or availability bias.
For example, the financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the coming years. The experience of such an adverse event increased their bias or likelihood that the event could reoccur. The economy recovered, and the market bounced back in the following years.
Loss Aversion
Loss aversion occurs when investors place a greater weight on the concern for losses than the pleasure from market gains. In other words, they’re far more likely to try to assign a higher priority to avoiding losses than making investment gains.
As a result, some investors might want a higher payout to compensate for losses. If the high payout isn’t likely, they might try to avoid losses altogether, even if the investment’s risk is acceptable from a rational standpoint.
Applying loss aversion to investing, the so-called disposition effect occurs when investors sell their winners and hang onto their losers. Investors’ thinking is that they want to realize gains quickly. However, when an investment loses money, they’ll hold onto it because they want to return to their initial price. Investors tend to admit they are correct about an investment quickly (when there’s a gain).
However, investors are reluctant to admit when they made an investment mistake (when there’s a loss). The flaw in disposition bias is that the performance of the investment is often tied to the entry price for the investor. In other words, investors gauge the performance of their investment based on its entry price, disregarding any fundamentals or attributes of the investment that may have changed.
Familiarity Bias
Familiarity bias occurs when investors invest in what they know, such as domestic companies or locally owned investments. As a result, investors are not diversified across multiple sectors and types of investments, which can reduce risk. Investors tend to go with investments they have a history with or are familiar with.
Familiarity bias can occur in so many ways. You may resist investing in a specific company because of what industry it is in, where it operates, what products it sells, who oversees the management of the company, who its clientele base is, how it performs its marketing, and how complex its accounting is.
Behavioral Finance in the Stock Market
The efficient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality.
The EMH is generally based on the belief that market participants view stock prices rationally based on all current and future intrinsic and external factors. When studying the stock market, behavioral finance believes that markets are not fully efficient. This allows for observing how psychological and social factors can influence the buying and selling of stocks.
The understanding and usage of behavioral finance biases can be applied to stock and other trading market movements on a daily basis. Behavioral finance theories have provided more precise explanations of substantial market anomalies like bubbles and deep recessions. At the same time, investors and portfolio managers who are not a part of EMH have a vested interest in understanding behavioral finance trends. These trends can help analyze market price levels and fluctuations for speculation and decision-making purposes.
What does behavioral finance tell us?
Behavioral finance enables us to comprehend how human emotion, biases, and cognitive limitations of the mind in processing and responding to information greatly influence financial decisions regarding investments, payments, risk, and personal debt.
How Does Behavioral Finance Differ From Mainstream Financial Theory?
On the other hand, mainstream theory makes the assumptions in its models that people are rational actors, are free from emotion or the effects of culture and social relations, and are self-interested utility maximizers. It also assumes, by extension, that markets are efficient and firms are rational profit-maximizing organizations. Behavioral finance counters each of these assumptions.
How does knowing about behavioral finance help?
By understanding how and when people deviate from rational expectations, behavioral finance provides a blueprint to help us make better, more rational decisions when it comes to financial matters.
What Is an Example of a Finding in Behavioral Finance?
Investors are found to systematically hold on to losing investments far too long than rational expectations would predict, and they also sell winners too early. This is known as the disposition effect and extends the concept of loss aversion to investing. Rather than locking in a paper loss, investors holding losing positions may even double down and take on greater risk in hopes of breaking even.
Conclusion
- Behavioral finance is an area of study focused on how psychological influences affect market outcomes.
- Behavioral finance can be analyzed to understand different outcomes across various sectors and industries.
- One of the critical aspects of behavioral finance studies is the influence of psychological biases.
- Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity tendencies.
- The efficient market theory, which states all equities are priced somewhat based on all available public information, is often debunked for not incorporating irrational emotional behavior.
