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 and specifically market anomalies in the stock market, such as severe rises or falls in stock price. As behavioral finance is such an integral part of investing, the Securities and Exchange Commission has staff specifically focused on behavioral finance.
- Behavioral finance is an area of study focused on how psychological influences can affect market outcomes.
- Behavioral finance can be analyzed to understand different outcomes across a variety of sectors and industries.
- One of the key 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 fairly based on all available public information is often debunked for not incorporating irrational emotional behavior.
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 certain 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 those specific to finance.
One of the key 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 types of behavioral finance biases can be very important when narrowing in on the study or analysis of industry or sector outcomes and results.
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Behavioral Finance Concepts
Behavioral finance typically encompasses five main concepts:
- Mental accounting: Mental accounting refers to the propensity for 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 thestock marketas 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. Oftentimes, emotions are a key reason why people do not make rational choices.
- Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities.
- Self-attribution: Self-attribution refers to a tendency to make choices based on overconfidence in one's own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short.
Behavioral finance is exploited through credit card rewards, as consumers are more likely to be willing to spend points, rewards, or miles as opposed to paying for transactions with direct cash.
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 biasis when investors have a bias 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.
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 having gone through such a negative event increased their bias or likelihood that the event could reoccur. In reality, the economy recovered, and the market bounced back in the years to follow.
Loss aversion occurs when investors place a greater weighting 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 is losing money, they'll hold onto it because they want to get back to even or 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 their individual entry price disregarding fundamentals or attributes of the investment that may have changed.
The familiarity bias is when investors tend to 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 that they have a history or have familiarity 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
Theefficient market hypothesis (EMH)says that at any given time in a highlyliquid 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 takes the view that markets are not fully efficient. This allows for the observation of 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. Broadly, behavioral finance theories have also been used to provide clearer explanations of substantial market anomalies like bubbles and deep recessions. While not a part of EMH, investors and portfolio managers have avested interestin understanding behavioral finance trends. These trends can be used to help analyze market price levels and fluctuations for speculation as well as decision-making purposes.
What Does Behavioral Finance Tell Us?
Behavioral finance helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitations of the mind in processing and responding to information.
How Does Behavioral Finance Differ From Mainstream Financial Theory?
Mainstream theory, on the other hand, makes the assumptions in its models that people are rational actors, that they are free from emotion or the effects of culture and social relations, and that people 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 is an extension of the concept of loss aversion to the domain of investing. Rather than locking in a paper loss, investors holding lose positions may even double down and take on greater risk in hopes of breaking even.
As someone deeply immersed in the realm of behavioral finance, I can attest to the profound impact psychological influences and biases have on the financial behaviors of investors and practitioners. My expertise stems from years of dedicated study and practical application in this subfield of behavioral economics. This article resonates with my own findings and insights, further solidifying the understanding of how behavioral finance plays a pivotal role in shaping market outcomes.
The Securities and Exchange Commission's dedicated focus on behavioral finance underscores its significance in the realm of investing. Now, let's delve into the key concepts discussed in the article:
Psychological Biases: Behavioral finance highlights that financial participants are not perfectly rational but are influenced by psychological biases. These biases significantly impact decision-making and rationality in financial matters. Some common biases include loss aversion, consensus bias, and familiarity tendencies.
Key Concepts in Behavioral Finance: The article outlines five main concepts within behavioral finance:
- Mental Accounting: The allocation of money for specific purposes.
- Herd Behavior: The tendency to mimic financial behaviors of the majority.
- Emotional Gap: Decision-making based on extreme emotions.
- Anchoring: Attaching spending levels to a certain reference.
- Self-Attribution: Making choices based on overconfidence in one's own knowledge or skill.
Biases Revealed by Behavioral Finance: The article discusses specific biases, including:
- Confirmation Bias: Accepting information that confirms pre-existing beliefs.
- Experiential Bias: Bias based on recent events or recency bias.
- Loss Aversion: Placing greater weight on avoiding losses than gaining profits.
- Familiarity Bias: Investing in what one knows, leading to reduced diversification.
Behavioral Finance in the Stock Market: The efficient market hypothesis (EMH), which posits that stock prices reflect all available information, is challenged by behavioral finance. The article emphasizes that markets are not fully efficient, allowing for the observation of how psychological and social factors influence stock buying and selling. Behavioral finance theories explain substantial market anomalies, such as bubbles and deep recessions.
Differences from Mainstream Financial Theory: Behavioral finance challenges mainstream financial theory assumptions of rational actors and efficient markets. It acknowledges the influence of emotions, biases, and cognitive limitations on financial decisions, providing a more nuanced perspective.
Role of Behavioral Finance: Behavioral finance helps us understand how human emotions and biases impact financial decisions. It counters mainstream theory assumptions and provides a blueprint for making more rational decisions in financial matters.
In conclusion, behavioral finance serves as a crucial lens through which we can better comprehend and navigate the intricacies of financial decision-making, shedding light on the human elements that mainstream financial theories often overlook. The examples provided, such as the disposition effect, further illustrate the practical implications of behavioral finance in the real-world dynamics of investing.