What is Behavioral Finance?

By: Kaplan Financial Education
July 23, 2021

Behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts. The reddit, Gamestop, Robinhood, and Melvin Capital story of early 2021 is an example from today’s news of how irrational, biased, and emotional investors move the markets. In this article, we define behavioral finance, and break down its components for better understanding.

Behavioral Finance Definition: What does Behavioral Finance mean?

Behavioral finance is the study of psychological influences on investors and financial markets. At its core, 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 the decisions they make are often flawed. If you are wondering how emotions and biases drive share prices, behavioral finance offers answers and explanations.

Behavioral finance originated from the work of psychologists Daniel Kahneman and Amos Tversky and economist Robert J. Shiller in the 1970s-1980s. They applied the pervasive, deep-seeded, subconscious biases and heuristics to the way that people make financial decisions. At about the same time, finance researchers began to propose that the efficient market hypothesis (EMH), a popular theory that the stock market moves in rational, predictable ways, doesn’t always hold up under scrutiny. In reality, the markets are full of inefficiencies due to investors' flawed thinking about prices and risk. 

In 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 blueprint to help everyone make better, more rational decisions when it comes to their finances.

Understanding Economic Behavior and Economic Psychology

Understanding economic behavior and economic psychology is a field of study called behavioral economics. It uses psychology and economics to explore why people sometimes make emotional rather than logical decisions and why their behavior does not follow the predictions of accepted economic models. It looks for answers to questions such as why even experienced investors buy too late and sell too soon, or why someone doesn’t use their savings account to help with paying off massive credit card debt. It even studies anomalies such as the small but measurable advantage companies have in the market if their stock ticker abbreviations come first in the alphabet, or the effect of the weather on market values.

Behavioral economics has also identified that systematic errors and biases recur predictably in certain circumstances, offering a framework for understanding when and how people make mistakes. There are two types of human behavior that factor heavily in behavioral economics: heuristics and biases.

Understanding Economic and Financial Heuristics

According to behavioral economist Herbert Simon, most people use heuristics when confronted with a complex decision. Heuristics are mental shortcuts we use to decide something quickly or not at all. Investors and financial professionals often use heuristics when analyzing investment decisions. Heuristics are often based on assumptions or rules of thumb that often but not always, hold true.

An example of a common heuristic is to assume that past investment performance indicates future returns. Although that seems to make sense on the surface, it doesn’t take into account changes in the economy, or how fully valued a stock has become. An investor might assume that because an emerging markets equity mutual fund has posted positive returns for the past five years, a sensible decision would be to maintain or increase the position in the fund. However, it is possible that the mutual fund has undergone a turnover in management, or oil prices have risen which affects shipping costs to these markets, for example. A mental shortcut in investment analysis can have an adverse effect on a portfolio.

Another example is seeing a “sale price” and assuming that it’s a good deal because it’s below the normal price. Sometimes it is a good deal, but other times it isn’t. This heuristic is based on the tendency to believe a reference point is real because of how it is reported. In this case, it’s the price a tag says is the normal price. Making a purchase decision based on an inaccurate reference number can result in negative financial consequences. 

Fortunately, when people become aware of errors caused by heuristics, they can adjust their decision-making processes. Not only that, but they can also learn which heuristics are reliable. In finance, some heuristics, such as the 10% savings rule, the 70% replacement ratio in retirement rule, and the ‘“cost-per-use” strategy to make purchasing decisions are effective.

Understanding Behavioral Finance Biases

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

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

  • Confirmation bias: Paying close attention to information that confirms a finance or investment belief and ignoring any information that contradicts it.

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

  • Framing bias: Reacting to a particular finance opportunity based on how it is presented.

  • Anchoring bias: Letting the first price or number encountered unduly influence your opinion.

  • Loss aversion: Trying to avoid a loss more than on recognizing investment gains, so that desirable investment or finance 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 well-considered investments.

Trading Psychology

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

Market Psychology

Human economic and financial heuristics and biases affect economic markets, the odd mix of collective and independent decisions of millions of people, acting for themselves and on behalf of funds or companies. As a result, many markets are not successful for many years. Understanding what causes the anomalies in valuations of individual securities and the stock market can result in better market performance.

Cognitive Errors

Suboptimal financial decision-making is the result of cognitive errors, many of which are made because of heuristics and anchoring, self-attribution, and framing biases. Exploring neuroscience discoveries and the implications for financial decision-making under uncertainty can result in sounder strategies for client debiasing 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.

Read more about the role that understanding emotional intelligence plays in behavioral finance.

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 growing in importance as the basis of an investment methodology. It is now possible to earn a behavioral finance designation. It’s something to consider if you want to understand the markets or excel as a financial advisor.

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