All about behavioral finance

Why do even experienced investors buy too late and then sell too early? Why do companies with stock symbols that arrive earlier in the alphabet have a small measurable advantage over those that arrive later? Another question is:  Why do people refuse to withdraw money from a savings account, even when they are drowning in debt? To answer these questions, we must delve into the psychology of investors and study their behavior. In doing so, you are doing what has been called behavioral finance.

Behavioral finance developed in part in response to the efficient market hypothesis. It is a popular theory that the stock market moves rationally and predictably. Stocks generally trade at their fair price, and these prices reflect all available information available to everyone. You can't beat the market, because everything you know has already or will soon be reflected in market prices.

The team of Finance de Demain has come together to bring you everything you need to know about behavioral finance. In fact, an understanding of financial psychology and behavioral finance can be an advantage in two ways.

First, understanding the different ways our decision-making can be affected can help us avoid common stock market pitfalls.

Secondly, an understanding of the financial behaviors of other market participants can help us identify opportunities. The best time to enter new trades or make investments is when others are making mistakes.

But before you begin, learn more about quantum finance.

Let's go

🥀 What is behavioral finance?

Behavioral finance is the study of psychological influences on investors and financial markets. Basically,behavioral finance is about identifying and explaining inefficiency and mispricing in financial markets. It uses experiments and research to demonstrate that humans and financial markets are not always rational and that the decisions they make are often wrong.

If you wonder how emotions and biases influence stock prices, behavioral finance offers answers and explanations.

Behavioral finance comes from the work of psychologists Daniel Kahneman and Amos Tversky and economist Robert J. Shiller in the 1970s and 1980s. They applied pervasive, deep-rooted, subconscious biases and heuristics to the way people make financial decisions.

Around the same time, finance researchers began to suggest that the efficient market hypothesis, a popular theory that the stock market moves in a rational and predictable way, does not always stand up to scrutiny. In reality, markets are rife with inefficiencies due to investors' misguided thinking about price and risk.

Over the past decade, behavioral finance has been embraced in the academic and financial communities as a subfield of behavioral economics influenced by economic psychology.

By showing how, when, and why behavior deviates from rational expectations, behavioral finance provides a model to help everyone make better, more rational decisions about their finances.

🥀 Traditional VS behavioral finance

Much of the financial theory developed over the past decades treats investors as rational. This is in line with the broader field of economics which also views decision makers as rational. The modern portfolio theory and the efficient market hypothesis are the two most cited theories about traditional investing.

Both make a series of assumptions about investment decision making. Among these are the assumptions that investors seek to maximize returns and that investors are rational. Behavioral investing theory explores the fact that investors are not rational.

It also takes into account the various motivations of investors to make decisions. To some extent, this explains some discrepancies between financial models and actual results.

If you understand financial psychology, it will help you understand some flaws in traditional finance. You will also be more aware of your own cognitive biases and mistakes you might make as an investor.

The field of quantitative investing also attempts to incorporate real-world results, rather than theory, into decision-making.

🥀 Behavioral Finance vs Behavioral Economics

Behavioral finance is concerned with how psychological and social factors affect decision-making specifically in financial markets. Behavioral economics explores many of the same “non-rational” factors that can influence decision-making.

However, in this case their effect on a wider range of decisions is studied. This can include how consumers and business leaders make decisions. It also includes game theory and evolutionary psychology.

These concepts can be used when studying or forecasting almost any economic measure, from spending and consumer confidence to debt, growth and unemployment. Additionally, the term financial psychology is often used to refer to a slightly different topic.

Financial psychology is often used in the broader field of personal finance. This includes savings, expenses, debts, credit cards and insurance. Financial planners and advisors are as concerned with these factors as they are with investment decision-making.

🥀 Understand the biases of behavioral finance

When economic and financial heuristics lead to inaccurate judgments and beliefs, cognitive biases result. The most common cognitive biases include:

Self-attribution bias: believing that good investment results are the result of skill and undesirable results are caused by bad luck.

Le Confirmation bias: pay close attention to information that confirms a belief in finance or investing and ignore any information that contradicts it.

Representative bias: Believing that two things or events are more closely correlated than they actually are.

Le Framing bias: Respond to a particular financial opportunity based on how it is presented.

Anchor bias: let the first prize or number encountered unduly influence your opinion.

Loss aversion: trying to avoid a loss rather than recognizing investment gains, so that desirable investment or financing opportunities are missed.

These biases and the heuristics that helped create them affect investor behavior, market and trading psychology, cognitive errors, and emotional reasoning.

🥀 Investor behavior

Overconfidence, excessive optimism, self-attribution bias, framing bias and loss aversion often lead investors astray. All of these factors lead to irrational rather than thoughtful investments.

Business Psychology

Trading psychology refers to the mental state and emotions of a trader that determine the success or failure of a trade. Assumption heuristics, such as positive outcome-based decision making, anchoring bias, loss aversion, and confirmation bias, can produce less than desirable investment or financial outcomes.

Market Psychology

Human economic and financial heuristics and biases affect economic markets, the strange mix of collective and independent decisions of millions of people, acting for themselves and on behalf of funds or corporations. As a result, many markets fail for many years.

Understand what causes anomalies in the valuations of individual securities and the stock market can lead to better market performance.

Cognitive errors

Suboptimal financial decision-making is the result of cognitive errors, many of which are due to heuristic and anchoring, self-attribution, and framing biases. Exploring findings in neuroscience and their implications for financial decision-making under conditions of uncertainty can lead to more insightful strategies for client bias reduction and financial management.

emotional reasoning

Many investors believe that their heuristics and biases are examples of sound scientific reasoning and therefore should be used for investment decisions. They are surprised to learn that they are emotional, not logical.

🥀 The Costs of Irrational Financial Behavior

Behavioral finance recognizes that investors have limits to their self-control and are influenced by their emotions, assumptions and perceptions. These biased and irrational behaviors have real costs.

They help account for the difference between what investors should earn and what they actually manage to take home. DALBAR, a financial research company, has conducted numerous studies comparing investors' rate of return to market performance.

For example, the average equity investor earned an average annual return of 4,25% over the 20 years between 2000 and 2019. At the same time, the S & P 500 had increased by 6,06%.

Fixed-income investors also left money on the table, gaining 0,47% over those 20 years. Along with a common bond index fund, the Bloomberg Barclays US Aggregate Bond Index, gained a little more than 5% per year.

If investors were rational, it seems they should have been able to get much closer to the S&P 500, or even surpass it if they were willing to take on more risk. But they did worse.

🥀 Basic concepts of behavioral finance

Since biases can arise for a variety of reasons, professionals use behavioral finance concepts to analyze the cause and effect of these biases. Professionals often separate the concepts of behavioral finance into these five categories:

mental accounting

Mental accounting is the tendency of individuals to save and allocate money for specific purposes. This can cause individuals to place different values ​​on the same amount of money. Because people classify funds differently, it can lead to irrational, or at least irregular, financial activity.

To compensate for mental accounting, many finance professionals encourage their clients to recognize mental accounting and assign equal value to equal amounts of assets.

Herd behavior

Herd behavior refers to the tendency of individuals to imitate the financial decisions of others. For example, if a person notices that others are investing in a certain action, it can motivate them to do the same. Professionals witness this concept in many aspects of society, but it is particularly prevalent in financial decisions.

Sometimes when herd behavior affects an individual, it jeopardizes their ability to make an informed decision, because herd behavior causes individuals to assume that other people are doing research for their decisions, skipping the step for them- same.

emotional gap

An emotional gap describes when extreme emotion drives an individual's financial decisions. In finance, the emotions that often make up an emotional void are anxiety, greed, enthusiasm, and fear. Emotional shortcomings can affect an individual's ability to make the best financial decisions. Therefore, finance professionals often try to offer rational advice to their clients instead.

Anchoring

The concept of anchoring examines what an individual bases their financial decisions on. Often this means assigning a value to financial assets based on a fixed reference point, such as the average price. For example, if a trader sees that a certain stock is priced at $100, they can use that purchase price as a benchmark to determine the true value of the stock. This causes individuals to ignore other indicators of value.

Self-attribution

Self-attribution is the tendency to make decisions based on an overestimation of one's own skills. Some behavioral finance experts view self-attribution as a form of emotional disconnect.

This may mean that an individual considers their knowledge to be above the levels of other professionals. Individuals can avoid self-attribution by listening to the advice of financial professionals and researching the possible outcomes of a decision before committing to it.

🥀 Behavioral finance is a growing field

Behavioral finance is now being implemented in financial advisor business models and client engagement practices. For financial analysts, asset managers and the investment process itself, behavioral finance is also gaining importance as the basis of an investment methodology.

It is now possible to obtain a behavioral finance designation. This is something to consider if you want to understand the markets or excel as a financial advisor. A good financial planning help you to.

Conclusion

Behavioral finance shows that individuals do not necessarily make their decisions based on a rational analysis of all information. This can lead to moves away from a fair price for an individual company's stock, and the market as a whole at a time when stock prices are collectively very high or very low.

A thorough understanding of all the different behavioral biases and potential impacts of behavioral finance is not required at this level, but the terms and concepts discussed in this article may appear in an exam question. But before you leave, here is a training course that will teach you how to sell advice on the internet. Click here to buy it.