Behavioral Finance - Overview, Examples and Guide (2024)

What is Behavioral Finance?

Behavioral finance, as the term implies, is the study of human behavior in a financial context. Human beings are imperfect relative to the conditions assumed for most financial theories. This is why their behavior creates anomalies within the financial markets.

This discipline of finance intends to explain why people behave the way they do and the impact of their behavior on the market as a whole.

It can give us some insight into the causes behind suboptimal behaviors and help plan remedial actions to reduce their negative impact on the financial well-being of individuals.

Behavioral finance is a specialized class of finance. It deals with individuals' psychological and emotional characteristics that make them deviate from standardized theories of rationality. Such behavior is often responsible for the individual's financial detriment.

Exhibiting behavior of this kind is deemed an anomaly for traditional financial theorists. It is also seen as a cause for disruption in the markets' normal proceedings leading to market imperfections.

It is important to study why such anomalies exist and how their impacts can be managed. Knowledge in this regard may help attain more financially favorable conditions and decisions.

Understanding behavioral finance

It wasn't until the late 1970s that people started to question the soundness of financial theories.Richard Thaler,Amos Tversky, andDaniel Kahnemanwere the pioneers who put forth the idea. They believed that standard finance bases its concepts on assumptions unattainable in the real world.

They suggested using psychology to explain anomalous financial behaviors of individuals. Their findings showed how human beings are normal instead of rational. But, unfortunately, this normality makes them quite prone to making errors of judgment.

They use mental shortcuts and let their emotions get in the way of optimal decision-making.

The efficient market hypothesis states that stock prices reflect all information. The information may or may not be publicly available, and no market participants can outperform the market. This cannot be true.

In the unlikely event that all market investors have the same information, they would still perceive and interpret it differently. Their decisions, as a result, would be different, and the uniformity principle of the EMH will become void.

The stock market crash is an irrefutable example of how unnatural it is to assume the EMH to function in the real world.

Behaviorists intend to explain the causes of such behavioral anomalies. Such explanations can help provide mitigating strategies so that individuals become aware and do not fall prey to these cognitive or emotional traps.

Traditional vs. Behavioral Financial Theories

Standard theories of finance and economics have always tried to fit the world into their mold of perfection. They expect that markets, securities and commodities, and even humans will conform to the principles of perfect information, perfect rationality, and perfect self-interest.

It is easier for financial models to work by assuming all conditions to be perfect. The alternative would be having to tailor already complex concepts according to each whim of the human brain.

Behaviorists defined the term "Bounded Rationality." It explains behavior that is less than optimal. For example, decisions made using heuristics result from bounded rates. Likewise, those affected by emotions and impulses fall under bounded rationality.

All these lead to unfavorable outcomes. It assumes that humans are not rational but have bounded rationality. They make decisions in the presence of various psychological, social and emotional factors to the best of their ability.

Traditional theories of finance assume:

1. The market and investors to always be rational.
2. Investors are self-serving, and their decisions are based on material gain only.
3. Investors can exercise perfect self-control.
4. Investors' information processing is free of any cognitive or emotional biases.

Behavioral finance assumes:

1. Investors are normal and not rational
2. Investors are emotional beings who cannot make cold and calculating decisions
3. Investors have different psychological traits that hinder their decision-making processes
4. Investors often use mental shortcuts to make decisions

Behavioral Finance Concepts

Behavioral finance allows for individuality in investors. It acknowledges that all human beings are different in their cognitive abilities, in their thoughts and feelings about things, and in the way they process information.

The reasons for imperfect behavior by individuals or investors in marketplaces are all driven by either cognitive or emotional factors. These are termed behavioral biases.

Biases can be defined as unfair inclinations of an individual toward a certain decision that cannot be backed by logic but has roots in the individual's psychological traits.

These biases are studied in depth by a major part of the field of this finance. It tries to explain their causes and the kinds of impact they may have on the decision outcomes.

There are two kinds of biases.

1. Cognitive biases;
2. Emotional biases

Cognitive biases arise due to errors in cognition or understanding of the information or a situation in which a decision is to be made. Emotional biases arise due to human impulses. These, when not controlled adequately, hinder decision-making.

The foundation of economic and financial theory is the presumption that people will make informed decisions and behave rationally and that markets will function effectively. However, it is not usually the case.

Behavioral finance explains an investor's illogical actions. Strongly embedded prejudices that are deeply ingrained in our psyche are the cause of these erroneous actions. These biases are divided into cognitive and emotional categories.

Biases Revealed by Behavioral Finance

The following is a list of the most commonly observed biases that investors may be vulnerable to.

Understanding these biases can help them make more informed decisions by remaining wary of these faulty behaviors.

1. Overconfidence Bias

Overconfidence is when an individual begins to overly accredit himself for previous successful financial endeavors.

As a result, he becomes more confident in his ability or talent to make such decisions and less cautious than he should otherwise be.

Such behavior is termed overconfidence bias and can often lead to reckless decisions with negative outcomes.

2. Mental Accounting

People tend to divide the money they have into mental accounts. They base these divisions on their origin, whether earned or gotten as a refund or won in the lottery.

For instance, money earned is to be budgeted and utilized, while that from a lottery can be freely spent.

No matter where it comes from, money needs to be allocated responsibly. However, giving in to such tendencies may lead to irrational investments and spending behaviors.

3. Illusion Of Control Bias

The illusion of control bias can be understood as an extension of the overconfidence bias. So it is when people assume they have more control over a situation than they do.

This inflated sense of control can lead to misguided risk assessments and harm the financial well-being of an individual.

4. Familiarity Bias

People gravitate to situations, places, and even people like themselves or to whom they can relate.

Such a bias can cause an individual to only invest in stocks of companies they know of or in their own country. This could lead to under-diversification in their portfolios, making them assume greater risk than they should.

5. Confirmation Bias

Individuals tend to accept new information when it confirms their beliefs. And less likely when it contradicts them. This selective bias in undertaking information is called confirmation bias.

Being biased in information about an investment decision can hurt the investor, as they do not consider all available information before doing so. They may leave out essential bits that could alter their entire perspective about an investment.

6. Availability Bias

is also sometimes called recency bias. Investors prone to availability bias tend to let recent events overshadow future ones. They expect similar trends to continue as before.

For example, a market boom can leave investors optimistic about price growth. However, such optimism may cause them to become risk-seeking while making investments, believing their returns would continue to grow.

The financial crisis of 2008 followed a bleak view of the stock market, causing many investors to stop trading altogether.

It is important to note here that each high follows a low and vice versa; that is how the market operates.

7. Hindsight Bias

People often claim to have predicted a certain outcome after it has come to pass. However, they realize in hindsight that they knew what would happen.

Such notions are misguided and prompt the question of why they didn't act if they knew beforehand what would happen.

Further, this bias makes people blind to their mistakes, hence their ability to learn from them and take remedial action.

8. Self-Attribution Bias

Self-attribution is a behavior where an investor is likely to attribute all his successful endeavors to his intrinsic knowledge, skills, or abilities. At the same time, any suboptimal outcomes are blamed on external factors.

It is also known as self-serving bias. This behavior can also stem from undue overconfidence that the investor may have about his knowledge or skills relative to others.

9. Representative Bias

Representative bias is a mental shortcut used to process information seemingly more efficiently. It makes them think two things or events are more alike than they are, so they start to expect similar outcomes.

This causes them to make irrational decisions.

Vigilant information gathering and processing can help avoid such a bias and consequent decision blunders.

10. Framing Bias

Investors can be vulnerable to interpreting the same information differently when worded in the frame of gain or loss. This prevents them from objectively assessing the underlying situation and making faulty decisions based on the presented information.

A closer analysis of given information can allow for better decisions and outcomes.

11. Anchoring Bias

While researching, individuals anchor themselves to the first information they find. Therefore, each finding is compared to the first to make information processing easier.

In this approach to the research process, individuals miss out on chunks of relevant information. Moreover, it sets an inappropriate standard for judging all later information. This results in a biased interpretation of the situation.

12. Loss Aversion

As the term indicates, an investor tends to avoid realizing losses at all costs. Investors become far more concerned about not incurring a loss than realizing gains.

As a result, they make decisions based on the sentiments associated with bearing a loss. This behavior can cause them larger than anticipated losses.

The disposition effect is a phenomenon that takes place when investors exhibit loss aversion. It is when they sell profitable investments sooner than is appropriate, fearing that those gains might disappear.

And postpone selling any losing investments longer than is rational in hopes that the price will bounce back and the investor would at least break even, if not make a profit off it.

13. Herd Behavior

Herd behavior is a universal psychological trait. It causes people to do what others are doing and often jump in without a second thought.

In the event of a loss, herd behavior makes investors believe they share that loss with others who made the same choice. This makes them feel that the loss hurts less than it would have. Otherwise, they were the ones against the crowd.

Studies show that people find it harder to go against the crowd. Even when their instincts point that way, they find it easier to stifle their instincts.

Herd behavior is very common in the stock market. It often causes dramatic trends in buying and selling.

14. Gambler's fallacy

Gamblers fallacy refers to investors' perception that causes them to assume a trend's reversal. This is quite comparable to what a gambler could experience at a casino.

If the die has been landing on black numbers during recent turns of the roulette wheel, the player will make his bets on a red number in the hopes that the pattern will change.

Similarly, people often think that a stock failing for a while would see a trend reversal, becoming a solid buy.

Impact On Decision-Making

Behavioral finance attempts to understand how emotions and cognitive flaws affect investors' decision-making processes. This finance differs from conventional wisdom because it holds that not all financial decisions are made with complete reason.

According to conventional financial theories, people should carefully weigh risk and return considerations before making investment decisions to maximize their earnings and minimize losses.

The classic financial theory is contested by behavioral finance, which contends that various biases influence investors' investing choices.

These include regret aversion, framing, and disposition effect as developed by prospect theory, as well as heuristic biases like anchoring, representativeness, the gambler's fallacy, and more.

The decision-making process of any investor can be subject to one or more of the biases discussed above. The presence of all these biases and heuristics disruptsoptimal decision-making. And in the process, investors incur unprecedented losses.

It is thus important to learn about biases. First, figure out what biases we're most likely to exhibit and plan strategies to ensure we do not fall prey to them.

To summarize, better financial decisions can be made by;

• Conducting careful research before making each decision.
• Understanding biases, their causes, and their effects.
• Preventing behavioral traps.
• Prioritizing financial well-being over personal feelings about investments.

Conclusion

The field of behavioral finance has grown to be well-respected. Many of its supporters think this finance will become so integrated into conventional economics and business in the upcoming years that the difference won't even be necessary.

Since the economic theory of rational agents can no longer be upheld, real advancement in the field of economics requires the addition of research findings from the behavioral and psychological sciences.

Even though human conduct occasionally seems irrational, systemic deviations from pure reason can be modeled and examined. As a result, advisors and wealth managers can outperform the competition by adopting behavioral finance and making smarter decisions.

This finance offers a rationale for investors' utterly irrational financial decisions. Moreover, it illustrates how emotions and cognitive biases influence investors' decision-making.

Anchoring, overconfidence, herd behavior, and loss aversion are a few factors contributing to behavioral finance.

In essence, this approach looks into investor behavior patterns and aims to comprehend how these patterns influence investing choices.

It provides a framework for assessing active investing methods for investors and gives numerous insightful perspectives for investment professionals.

Researched and authored by Rishabh Bhoria|LinkedIn

Reviewed and edited by Parul Gupta |LinkedIn

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