Behavioral Finance: Concepts and Why it's Important

Updated: Mar 14

Get to know the psychological side of finance

The study of psychological influences on investors is called Behavioral Finance

It would be nice if all the investors and markets move solely based on fundamentals and economic and financial analysis of businesses. But at times investors lack self-control, act irrational, and make decisions based more on emotions than facts. The study of these influences on investors and markets is called behavioral finance.

What is Behavioral Finance?

You could say Behavioral Finance came about as a way to explain rationally the irrational behavior of markets and investors or, as one acclaimed economist put it, finance from a broader social science perspective including psychology and sociology.

The traditional financial theory holds that markets and investors are rational; investors have perfect self-control and aren't confused by cognitive errors or information processing errors.

Now, Behavioral Finance holds that investors are considered "normal," not "rational;" they have limits to their self-control, are influenced by their own biases, and make cognitive errors that can lead to wrong decisions.

Efficient Market Hypothesis

The study of Behavioral Finance, a sub-field of behavioral economics, arose in the 1980s, when cracks began to appear in what was then considered the Efficient Market Hypothesis.

The Efficient Market Hypothesis, or EMH, was an investment theory that held that share prices reflect all information about a particular investment or market at all times, so investors can't purchase undervalued stocks or sell stocks for inflated prices. Risk-adjusted excess returns, called alpha, cannot be consistent in EMH, meaning only inside information can result in outsize risk-adjusted returns. But if EMH were fact, it would be impossible to outperform the overall market even with expert stock-picking or market timing. The only way an investor could "beat the market" would be by purchasing riskier investments. Because of this, those with faith in EMH say there is no merit in searching for undervalued stocks or trying to predict market trends through either fundamental or technical analysis.

Random Walk Hypothesis

The Random Walk Hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus cannot be predicted.

If we take into account EMH, which states that asset prices reflect all available information which means every single people can predict the stock prices and they can create an optimally diversified portfolio to become rich. Many people thought that markets are efficient and won't fall since the subprime crisis. After that a French mathematician Louise Bachelier believed that share price movements were like the steps taken by a drunk; unpredictable. However, the theory became famous through the work of economist Burton Malkiel, who agreed that stock prices take a completely random path. The random walk hypothesis states that the best forecast of a company's stock price is based on today's price. If markets are unforecastable what can we do? Well, people won't act rationally in every situation. Intuition plays a vital role in the stock market where people act irrational rather than being rational. And that's what the random walk hypothesis says. If people were rational at every time the market would soar up and never fall.

Aspects of Behavioral Finance

Overconfidence (Thinking Bias) - People overestimate the probability of the things that they identify with and want to see happen.

Cognitive Dissonance - It refers to the mental conflict that occurs when one's beliefs are discovered to be wrong.

Mental Compartments - Most people don't apply scientific techniques like CAPM and Gordon Growth model for investments but they are highly irrational based on their personal preference while investing.

Attention Anomalies - People don't pay attention all the time to everything.

Anchoring - It refers to a tendency in ambiguous situations to allow one's decision to be affected by someone's choice.

Representativeness Heuristic - It is used when making judgments about the probability of an event under uncertainty

Disjunction Effect - The inability to make decisions in advance in anticipation of future information.

Magical Thinking - People think that their small individual actions can influence the course of events in the material world. An election is the best example where people think that their individual vote would bring up a change in society.

Quasi-Magical Thinking - It describes "cases in which people act as if they wrongly believe that their action influences the outcome, even though they do not really hold that belief ".

  • Newcomb's Paradox: People sometimes change their behavior when they learn about a prediction that has been made about the future. Let's take Box A which has 1000 dollars and Box B which has 10,000 dollars. If a person predicts what's inside those two boxes his behavior would change and obviously, he would pick Box B.

Culture and Social Contagion - It refers to collective memory. This explains that the investor invests from the beliefs of a group of people. The human mind is usually influenced fundamentally by stories about people. Let's take a man who invests a massive amount in a company. Obviously, the human mind is influenced by this act and instinctively people will invest in the same company.

Antisocial Personality Disorder - People acts against the interest of investors or financial markets. It's a kind of disorder where people's self-esteem from personal gain, being manipulative and deceitful.

Why is Behavioral Finance important?

If you have a passion for being involved in financial markets studying only the technical terms won't suffice to become a successful investor. The technical sides of finance don't have any formulas to calculate the behavior of people. That doesn't mean there is no use in studying the technical terms, we also need to be strong in the psychology and sociology sides of finance. This situation was not in the late 80s or 90s where only the rich invested in few private entities. During that time there were only a few investors and very few companies it was easy to understand their behavior. Later, people were explained about financial innovations which prick their conscience to invest. Hence the world turned out to be materialistic where many people constantly changed their behavior as per the market it is difficult to find the underlying behavior of investors using technical sides of finance. Therefore, apart from technicalities, it is necessary to understand the social and behavioral perspective of finance.

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