What is Behavioral Finance?
Behavioral finance explores how psychological influences and biases impact the behavior of investors and financial practitioners. In essence it investigates why investors make certain choices and assumes that investors are not perfectly rational. It also examines the effects of market anomalies on financial theories and models.
Behavioral finance attempts to understand and explain observed investor and market behaviors, which may appear irrational or suboptimal from a traditional finance perspective. Behavioral finance differs from traditional finance in that it focuses on how investors and markets behave in practice rather than in theory.
Key Learning Points
- Behavioral Finance attempts to understand and explain observed investor and market behaviors and focuses on how investors behave in practice rather than in theory
- People develop principles or beliefs based on their experiences, known as heuristics which influence their decision making
- Heuristics are imperfect and can lead to biases, making people susceptible to errors
- Investors’ decisions can be heavily influenced by how information is presented:
- Anchoring can cause investors to stick to initial information even when new data arises
- Framing can lead to different decisions based on whether options are presented as gains or losses
- Disposition Effect refers to the tendency to sell assets that have increased in value while holding onto assets that have decreased in value, influenced by loss aversion and the desire to avoid regret (this can lead to suboptimal investment strategies and reduced profit)
Understanding Behavioral Finance
A great demonstration of behavioral finance comes from a quote by Daniel Kahneman, one of the founders of Behavioral Economics:
“An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easy recognize that they are the same.”
Importance of Behavioral Finance
The importance of behavioral finance lies in its ability to provide insights into the psychological and emotional factors that influence investment decisions and market outcomes. It helps to explain why people sometimes make irrational financial decisions, and how these decisions can lead to market inefficiencies or predictable patterns. By understanding the biases and behaviors that drive investor actions, behavioral finance offers strategies to improve decision-making and potentially achieve better financial outcomes.
Behavioral finance also challenges the traditional assumption that markets are always efficient and that investors are always rational, highlighting the need for a more nuanced approach to financial analysis and investment strategy.
Market Efficiency and Behavioral Finance
Market efficiency and behavioral finance are two areas of study that intersect in the field of finance. Market efficiency refers to the concept that financial markets are “efficient” in reflecting all available information in the prices of securities. This implies that it is difficult to achieve returns that outperform the market average because any new information that could impact a security’s price is quickly incorporated into its market price.
Behavioral finance, on the other hand, challenges the notion of market efficiency by introducing psychological factors and biases that can influence investors’ decisions. It suggests that markets investors’ emotions and cognitive errors can lead to irrational behaviors and market anomalies. This can result in asset prices deviating significantly from their fundamental values, especially during times of uncertainty and are not always rational and that for investors to consistently high volatility.
The objective of behavioral finance is to understand and explain these observed investor behaviors and market anomalies. It aims to identify and modify behaviors that may appear irrational or suboptimal from a traditional finance perspective, potentially leading to more optimal economic outcomes.
Behavioral Finance Concepts
Behavioral finance concepts include a variety of psychological factors and biases. There are four key categories of psychological phenomena related to finance:
- Bias – a predisposition to error
- Heuristics – a mental shortcut or rule of thumb used to make decisions
- Framing Effect – the setting in which the decision is framed
- Regret Aversion – regret aversion is a behavior in which individuals make decisions to avoid the feeling of regret in the future.
Heuristics-driven Biases
People develop principles or beliefs based on their experiences, which they use for decision-making, these are known as heuristics. They are imperfect and can lead to biases, making people susceptible to errors.
Some key heuristic-driven biases are:
- Representativeness – this is when an event is assumed to be representative of a larger population or sample, for example, assuming a good company is a good stock
- Over-confidence – investors may be overconfident in their abilities, leading to less diversification and more susceptibility to volatility
- Anchoring – investors may make initial investment decisions based on available information and then fail to adjust adequately when new information arises
- Confirmation Bias – this leads to ignoring information or evidence that contradicts one’s views on an investment outcome, causing investors to stick to their initial beliefs regardless of market changes.
These concepts help explain why investors might deviate from the rational decision-making models assumed in traditional finance and how these deviations can lead to market inefficiencies or anomalies. Understanding these concepts is crucial for developing strategies to mitigate the impact of biases and improve financial decision-making.
Objectives of Behavioral Finance
The objectives of behavioral finance include understanding and explaining how psychological factors and biases influence financial decisions and market behaviors. It aims to identify behaviors that may appear irrational or suboptimal from a traditional finance perspective and modify them to more closely match those assumed under traditional finance models, potentially leading to more optimal economic outcomes.
Behavioral finance also seeks to understand the impact of cognitive biases and emotions on financial decision-making, ultimately improving financial outcomes and market efficiency by addressing these biases.
Behavioral Finance Examples
Overconfidence Study – Odean
Research by Terrance Odean in 1999 analyzed trades from 10,000 clients at a certain discount brokerage firm. The study wanted to ascertain if frequent trading led to higher returns. Over a one-year horizon the average return to a purchased security was 3.3% lower than the average return to a security sold.
In other words, the more active the retail investor, the less money they typically made. This study was repeated numerous times in multiple markets and the results were always the same. The authors concluded that traders are “basically paying fees to lose money“.
Anchoring Study – Russo & Shoemaker
- In this study, participants were asked: firstly, add 400 to the last three digits of your phone number and write it down. Now ask yourself whether Attila invaded France before or after that year.
- Secondly, what date do you think Attila actually invaded? Write that answer down too.
This experiment was conducted by Russo & Shoemaker in 1989, asking 500 MBA candidates when Attila invaded France. Critically, they were first asked to generate a random date based on their phone numbers. Despite knowing the number was irrelevant, it still influenced their judgement. When that date happens to range between 400 and 599, the candidates guess on average that Attila was beaten in 629 A.D. But when the generated date is between 1200 and 1399, they guess 988 A.D.
What range did your guess fall into and how did it compare to Attila’s invasion date of 451 AD? Was your judgement influenced?
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Behavioral Finance in the Stock Market
Behavioral finance in the stock market refers to the study of how psychological factors, biases, and emotions can influence investors’ decisions and behaviors in the stock market. It examines the impact of these factors on stock prices, trading patterns, and market anomalies.
Regret Aversion
Evidence suggests we try to avoid the feeling of regret as much as possible and often we will go to great lengths, sometimes illogical lengths, to avoid having to own the feeling of regret. Research shows that traders were 1.5 to 2 times more likely to sell a winning position too early and a losing position too late all to avoid the regret of losing gains or losing the original cost basis. By not selling the position and locking in a loss, a trader does not have to deal with regret.
Anchoring
Anchoring is the influence of arbitrary figures on people’s judgments and decisions, such as the impact of a random number on estimations or the effect of a seller’s asking price on negotiations.
In an experiment, subjects were asked to estimate the percentage of United Nations countries that are African. Before giving their estimate, they were asked whether their guess was higher or lower than a number determined by a roulette wheel, which was set to stop at either 10 or 65. Their subsequent estimates were significantly influenced by the initial number provided by the roulette wheel.
Disposition Effect
The Disposition effect is the tendency to sell assets that have increased in value and hold assets that have decreased in value, which is influenced by loss aversion and the desire to avoid regret.
An investor might sell a stock that has gained 20% in value to lock in profits, while holding onto another stock that has lost 20% in value, hoping it will recover, even though this may not be the most rational decision.
Framing
Framing or frame dependence is a concept in behavioral finance that explains the human tendency to react differently to a situation based on how it is presented or framed. This means that the way information is structured and delivered can significantly influence people’s decisions and judgments. For example, individuals may perceive the same outcome as more favorable if it is framed as a gain rather than a loss, even if the actual value is the same. This concept is crucial in understanding how cognitive biases and framing effects can lead to irrational financial decisions and behaviors.
Framing Study – Tversky & Kahneman
Tversky & Kahneman conducted a series of experiments asking participants to select a treatment in a hypothetical life and death situation:
- Treatment A
Saves 200 lives: 33% chance of saving all 600 people, 66% possibility of saving no one
- Treatment B
- people will die: 33% chance that no one will die, 66% probability that all 600 will die
Treatment A was chosen by 72% of participants when presented with positive framing dropping to 22% with negative framing.
Conclusion
Behavioral finance seeks to explain the psychological factors and biases that influence financial decisions and market behaviors. It challenges the traditional assumption of market efficiency by suggesting that investors are not always rational, and that emotions and cognitive errors can lead to market anomalies.
The field aims to identify and modify behaviors that deviate from rational decision-making models, potentially leading to more optimal economic outcomes. Behavioral finance highlights the importance of understanding human behavior in the context of financial decision-making and market dynamics.