Behavioral Finance is the application of psychology to finance and investing. It has produced deep insights into how investors think and behave as well as how financial markets behave. Learn more about what this new science tells us about how and why we invest.
What Is Behavioral Finance?
In March 1979, Israeli psychologists Daniel Kahneman and Amos Tversky published a paper entitled “Prospect Theory: An Analysis of Decision Under Risk”, ushering in a wave of new research on the way people think and behave, particularly in the face of risk and uncertainty. It was quickly determined that Prospect Theory had significant implications for financial and economic decisions and was viewed as a new form of “financial psychology”. Ultimately, it was adopted by economists as a science called Behavioral Economics and by the investment world as Behavioral Finance.
Before Prospect Theory, the financial and academic communities had established numerous mathematical models addressing finance, capital markets, trade and commerce, securities pricing, portfolio construction, and investment management, all of which had been based on the assumption that people acted rationally and that emotions played little or no part in the way people or markets behaved. Behavioral Finance research, however, suggests that irrational behavior and emotion-based decision-making are more prevalent than originally thought, casting some doubts on the accuracy of the classic financial theories of the day.
The industry has since warmed to behavioral finance, particularly as it applies to individual investors, and has embraced the new science as an important addition to investment management and financial planning services. Knowledge of the subject, for example, is now required for those seeking to become a Certified Financial Planner™ (CFP). In addition, the models used by institutional investors remain intact but have been adapted in some ways to accommodate behavioral factors.
Objectives of Behavioral Finance
There are both micro and macro elements of Behavioral Finance. The micro approach seeks to understand how an individual makes financial and investment decisions. The macro approach seeks to understand how the collective decisions of millions of people affect the overall performance of markets. The latter is particularly important for understanding market bubbles, crashes, or other performance anomalies, which classic theories fail to adequately explain.
Behavioral finance examines the neurological process of decision-making to understand how the various parts of the brain interact to make judgments and decisions when dealing with the uncertainties of financial issues. A major focus of the science deals with the way humans meld logic and reasoning with our more primal reactions and emotions. In his book “Thinking Fast and Slow” Kahneman simplifies this discussion by comparing our primitive reactions (fast thinking) with our reasoning ability (slow thinking) to show how they work together in subtle and subconscious ways to help people make decisions.
The result of this interaction is to make quick decisions, a trait that was critical to early human survival and is now embedded in our DNA through evolution. To make decisions quickly, the brain employs shortcuts called heuristics and enlists help from our emotions. The process gives us remarkable abilities to make quick decisions, but the price we pay is the accuracy that was compromised in those shortcuts. These inaccuracies in thinking show up in our behavior as biases.
What are Behavioral Finance Biases?
Biases are leanings or predispositions that influence our behavior. If you have a bias toward plant-based foods, your decisions about what to eat are made in that context. If you have a bias toward a company because you like their spokesperson, it could lead to you buying the stock as an investment, edging out other criteria about the stock that could be more relevant and important to its future financial prospects.
The shortcuts our brains use to process information coupled with our emotional makeup cause biases across the investing population that have been shown to have a significant impact on how people spend, save, and invest. As a result, the resulting biases plague a majority of investors, causing them to behave in ways that may not be in their best interests.
Biases are deeply ingrained in our subconscious minds, exerting an influence on almost all decisions we make. Because they operate outside conscious awareness, they can be very difficult to identify and avoid. There are, however, techniques people can employ to mitigate them or to work around them. Behavioral finance seeks to identify these biases and to help both individual investors, investment advisors, and financial institutions cope with them.
14 Investment Biases in Behavioral Finance
1. Ambiguity Aversion (also called Certainty Bias)
This is a bias toward more certain returns, even when those returns are expected to be lower than less certain alternatives.
Occurs when people are influenced by a number they become anchored to that affects subsequent judgments. One price we commonly anchor to is the price we paid for a stock, which biases our judgment about whether to sell it or hold it if it returns to that price.
3. Affect heuristic
People are influenced by the emotions they attach to an object and might buy or sell a stock because of a positive or negative emotion associated with the stock, rather than for logical investment reasons.
4. Availability Bias
A tendency to make judgments and decisions (especially the quick ones) based more only on readily available information in your memory
5. Belief Perseverance
Once people make a judgment or form an opinion, evidence shows a marked tendency to stick with and defend it, even when presented with compelling evidence to the contrary.
6. Disposition Effect
Causes people to be biased in favor of selling an asset to realize a gain but holding if there is an unrealized loss.
7. Endowment effect
Demanding more to part with an object than one would be willing to pay to acquire it.
Biases in judgment or decision-making that result from the manner or context in which the choices are presented.
9. Halo effect
The tendency of people to extend a virtual halo around a person, organization, or company that they like, which biases future judgments.
Tendency for people to emulate the behavior of others or to take actions similar to that of a group they identify with.
11. Loss aversion
A strong tendency to avoid realizing a loss, often associated with taking additional risk in an attempt to mitigate the loss.
12. Mental accounting
The tendency to view money differently depending on where it came from or how it will be used.
A widespread human trait to be overconfident about one’s attributes or abilities.
A tendency to draw conclusions from too little, anecdotal, or non-relevant data.
5 Tips for Overcoming Behavioral Investing Biases
Experts in behavioral finance will tell you that changing subconscious behaviors is not impossible, but it is very difficult and could require the help of a coach or expert. For investors looking to just remove or reduce the impact of biases on their own trading, there are other ways to deal with them. Several are listed below.
1. Identify Potential Biases by Keeping a Decision Journal
Keeping a simple record of your investing decisions will give you insights into your personal decision process. The key is to write down why you made those decisions. If you did that for a month or two, you would gain a lot of knowledge regarding your process and you would very likely discover areas in which your biases are holding you back.
2. Work with an Investment Buddy or In a Group
Bouncing ideas off others can open your perspective on how you are deciding what to buy or sell. Just be careful not to be herded by what others think or fall victim to their biases in the process.
3. Use Software Tools
Software tools can provide you with more data with which to make decisions and will do so in an impassioned way. This could mean using charting software, screening programs, or analysis packages.
4. Develop Rules and Disciplines that Allow Little Room for Judgment
Relying on our gut feelings or judgments is where we let in all the biases. The more rules and disciplines we can develop and use, the less our emotions will have a chance to influence us. In addition, if a disciplined rule is not working, you'll have evidence and can change it. If your intuition is not working, you have no remedy for that.
5. Use Managed Funds and ETFs or a Robo-Advisor
Ways to manage our investments without taking daily control abound. Millions of people are adopting techniques of passive investment management that reduce or eliminate the impact of their behavioral biases altogether.
Impact of Financial Biases on the Stock Market
Since a majority of investors (including professionals) exhibit biases, it is logical to expect that these biases show up in the overall behavior of stocks, sectors, and the market as a whole. While this is true, the market will reflect the sum of all biases and behaviors together, so isolating a particular bias in order to exploit it is quite challenging and can usually only be done by computer. Some professional traders have been able to detect exploitable biases in the noise of public trading and use that information to enhance their trading performance.
Another technique is to identify certain behavioral “factors”, such as the broad propensity of investors to skew their holdings toward growth stocks over value stocks, thereby setting up potential mispricing opportunities between the two groups. These factors are then used to modify large portfolios to favor the underpriced group.
Behavioral factors have also been blamed for bubbles and crashes as well, though they do not provide any easy answers as to how investors might avoid or exploit them.
Behavioral Finance has provided significant new insights into the investor mindset and market dynamics. While we cannot easily change our collective mindset, understanding it better can potentially lead to improved investment performance.
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