Understanding Behavioral Finance: The Psychological Side of Investing

understanding behavioral finance

Introduction to Behavioral Finance

Behavioral finance is an area of financial study that examines how psychology can influence the financial decisions of individuals and institutions. It questions the assumptions of traditional finance theory that investors always act rationally. Instead, it looks at the role of emotions, cognitive biases, and social forces in impacting financial decisions and market outcomes.

The field emerged in the late 1970s and early 1980s as psychologists Daniel Kahneman and Amos Tversky conducted studies on decision making under uncertainty. They identified several common biases that cause individuals to deviate from rationality. This challenged the efficient market hypothesis which stated that markets accurately reflect all available information.

In this short guide, I'll cover very briefly each of the most important topics that are discussed when trying to understand the psychological side of finance, known as Behavioral Finance.


Key Cognitive Biases and Heuristics

There are a number of well-documented biases and mental shortcuts that impact financial judgments. Understanding these can help investors become aware of their own limitations.

Overconfidence Bias

Many studies show that a majority of people rate themselves as above average on positive traits like intelligence, investing skill, and the ability to identify market bubbles. This overconfidence causes investors to trade excessively and often achieve lower than average returns.

"Individuals exhibit too much confidence in their ability to predict future events. The consequence is that most people trade too much." - Hersh Shefrin, Beyond Greed and Fear

Confirmation Bias

Investors often seek out and favor information that confirms their preexisting views while ignoring contradicting evidence. This confirmation bias impacts their ability to make objective decisions.

"Once we have formed a view, we embrace information that confirms that view while ignoring, or rejecting, information that casts doubt on it. Confirmation bias suggests that we don't perceive circumstances objectively." - Charles Rotblut

Anchoring Bias

When making estimates, investors often rely too heavily on the first piece of information they receive. This number then becomes an anchor that biases future judgments.

"When making decisions, humans tend to give disproportionate weight to the first information they receive. This is called the anchoring effect." - Morgan Housel

Availability Heuristic

Individuals tend to overweight events or scenarios that readily come to mind, often the most recent or emotionally charged ones. This can lead to making decisions based on memorable but unlikely events.

"People estimate the probability of an event based on how quickly past instances come to mind, rather than examining actual base rates. This mental shortcut leads to poor investing decisions." - Jason Zweig, author and investing columnist

Representativeness Heuristic

Rather than looking at base rates, people often evaluate scenarios based on how closely they match a stereotype. This can lead investors to make lookalike judgments without considering all variables.

"The representativeness heuristic is the tendency to judge the probability of an event by finding a 'comparable known' event and assuming that the probabilities will be similar." - Jason Zweig, Your Money and Your Brain


The Role of Emotion in Financial Decisions

Emotions inevitably influence investor choices for better or worse. Behavioral finance examines common emotional patterns and their market impacts.

Fear and Greed

Emotions like fear and greed are universally experienced during market bubbles and crashes. Fear can cause investors to irrationally sell out of positions at market lows. Greed might lead them to speculate rather than invest during bubbles.

“A common adage on Wall Street is that the markets are motivated by two emotions: fear and greed. Indeed, this book suggests that investors are affected by these emotions." - John Nofsinger

Regret Aversion

The feeling of regret over past decisions has been shown to influence investor choices. People often take actions to avoid feeling future regret even if those actions are suboptimal.

"Of all the emotions that influence investors, one of the most powerful is regret. Fear of regret can cause investors to hold onto losing investments too long or to rashly sell winners too early." ~ Meir Statman, Finance for Normal People

Herd Behavior

Rising asset prices can spark greed and hype that leads to herd behavior. Individuals join the crowd following price momentum due to FOMO despite potential overvaluation.

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one." - Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

The Role of Emotion in Finance

Explanations for Market Anomalies

Markets have exhibited several pricing anomalies that deviate from efficient market theories. Behavioral finance offers potential explanations grounded in investor psychology.

"Market efficiency does not require that market prices be accurate estimates of fundamental values at every instant. Rather, efficiency requires that errors in market prices be unbiased and uncorrelated." - Eugene Fama, Efficient Capital Markets: A Review of Theory and Empirical Work

Calendar Effects

Markets have historically shown effects related to the day of the week or month. The January effect sees increased returns while the weekend effect predicts negative Monday returns. These may arise from seasonal investor moods and behaviors.

"The 'January effect' on security returns is one of the best-known calendar-related anomalies." - James M. Poterba and Scott J. Weisbenner, Capital Gains Tax Rules, Tax Loss Trading, and Turn-of-the-Year Returns

Momentum Effect

Assets that have outperformed recently tend to continue doing so in the near term. This momentum effect could be explained by confirmation bias and herding among investors.

Overreaction and Underreaction

Stock prices have been shown to overreact to good and bad news in the short run while underreacting in the long run. This may reflect the biases of representative heuristics and anchoring.


Key Aspects of Investor Psychology

Behavioral finance also examines the psychological aspects that motivate investor decision making in areas like loss aversion, mental accounting, and self-control.

Loss Aversion

The pain of losses is felt more acutely than the pleasure of gains. Loss aversion causes investors to hold losing investments too long to avoid realizing losses.

Mental Accounting

Individuals use mental accounting rules to think about money for budgeting. But irrational rules often guide financial decisions, like treating dividends differently than capital gains.

Lack of Self-Control

Evidence shows that investors often lack discipline in areas like saving or portfolio rebalancing. The tendency to prioritize immediate gratification impacts financial choices.

Behavioral Bias

Overcoming Behavioral Biases

While difficult to avoid, investors can take steps to minimize the impacts of biases through awareness and developing systematic investment processes.

Seeking Out Dissenting Views

Seeking different perspectives from advisors or research can counteract confirmation bias and result in more balanced thinking.

Conducting Thorough Research

Investing based on rumor or limited data can lead to availability bias. Thorough research on investments can yield more objective results.

Controlling Emotions

Reflecting on past periods where emotion influenced decisions can increase discipline going forward.

"While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster" - Benjamin Graham

Automated and Rules-Based Investing

Setting up systematic portfolio rebalancing takes some emotion out of investing. Similarly, dollar-cost averaging over time can overcome bad market timing.



Conclusion

Behavioral finance shows that human psychology plays a significant role in financial markets. Understanding common biases, heuristics, and emotional patterns provides investors a blueprint for making more rational decisions. While difficult to eliminate, investors can take proactive steps to minimize the impact of their own inherent biases. Further study of investor behavior and market inefficiencies remains an area requiring additional research.

 

To learn more about Behavioral Finance, check out my book review and summary of Beyond Greed & Fear, by Hersh Shefrin:

Beyond Greed & Fear, by Hersh Shefrin: Book Summary & Review
Back to blog

Leave a comment

Please note, comments need to be approved before they are published.