Behavioural Finance
Behavioral finance, a subfield of behavioral economics, proposes that psychological influences and
biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and
biases can be the source for the explanation of all types of market anomalies and specifically market
anomalies in the stock market, such as severe rises or falls in stock price. As behavioral finance is such an
integral part of investing, the Securities and Exchange Commission has staff specifically focused on
behavioral finance.
KEY TAKEAWAYS
Behavioral finance is an area of study focused on how psychological influences can affect market
outcomes.
Behavioral finance can be analyzed to understand different outcomes across a variety of sectors
and industries.
One of the key aspects of behavioral finance studies is the influence of psychological biases.
Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity
tendencies.
The efficient market theory which states all equities are priced fairly based on all available public
information is often debunked for not incorporating irrational emotional behavior.
Understanding Behavioral Finance
Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one area of
finance where psychological behaviors are often assumed to influence market outcomes and returns but
there are also many different angles for observation. The purpose of the classification of behavioral
finance is to help understand why people make certain financial choices and how those choices can
affect markets.
Within behavioral finance, it is assumed that financial participants are not perfectly rational and self-
controlled but rather psychologically influential with somewhat normal and self-controlling tendencies.
Financial decision-making often relies on the investor's mental and physical health. As an investor's
overall health improves or worsens, their mental state often changes. This impacts their decision-making
and rationality towards all real-world problems, including those specific to finance.
One of the key aspects of behavioral finance studies is the influence of biases. Biases can occur for a
variety of reasons. Biases can usually be classified into one of five key concepts. Understanding and
classifying different types of behavioral finance biases can be very important when narrowing in on the
study or analysis of industry or sector outcomes and results.
Behavioral Finance Concepts
Behavioral finance typically encompasses five main concepts:
Mental accounting: Mental accounting refers to the propensity for people to allocate money for
specific purposes.
Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the
majority of the herd. Herding is notorious in the stock market as the cause behind dramatic
rallies and sell-offs.
Emotional gap: The emotional gap refers to decision-making based on extreme emotions or
emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key
reason why people do not make rational choices.
Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may
include spending consistently based on a budget level or rationalizing spending based on
different satisfaction utilities.
Self-attribution: Self-attribution refers to a tendency to make choices based on overconfidence
in one's own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a
particular area. Within this category, individuals tend to rank their knowledge higher than
others, even when it objectively falls short.
Some Biases Revealed by Behavioral Finance
Breaking down biases further, many individual biases and tendencies have been identified for behavioral
finance analysis. Some of these include:
Confirmation Bias
Confirmation bias is when investors have a bias toward accepting information that confirms their
already-held belief in an investment. If information surfaces, investors accept it readily to confirm that
they're correct about their investment decision—even if the information is flawed.
Experiential Bias
An experiential bias occurs when investors' memory of recent events makes them biased or leads them
to believe that the event is far more likely to occur again. For this reason, it is also known as recency
bias or availability bias.
For example, the financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had
a dismal view of the markets and likely expected more economic hardship in the coming years. The
experience of having gone through such a negative event increased their bias or likelihood that the
event could reoccur. In reality, the economy recovered, and the market bounced back in the years to
follow.
Loss Aversion
Loss aversion occurs when investors place a greater weighting on the concern for losses than the
pleasure from market gains. In other words, they're far more likely to try to assign a higher priority to
avoiding losses than making investment gains.
As a result, some investors might want a higher payout to compensate for losses. If the high payout isn't
likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational
standpoint.
Applying loss aversion to investing, the so-called disposition effect occurs when investors sell their
winners and hang onto their losers. Investors' thinking is that they want to realize gains quickly.
However, when an investment is losing money, they'll hold onto it because they want to get back to
even or their initial price. Investors tend to admit they are correct about an investment quickly (when
there's a gain).
However, investors are reluctant to admit when they made an investment mistake (when there's a loss).
The flaw in disposition bias is that the performance of the investment is often tied to the entry price for
the investor. In other words, investors gauge the performance of their investment based on their
individual entry price disregarding fundamentals or attributes of the investment that may have changed.
Familiarity Bias
The familiarity bias is when investors tend to invest in what they know, such as domestic companies or
locally owned investments. As a result, investors are not diversified across multiple sectors and types of
investments, which can reduce risk. Investors tend to go with investments that they have a history or
have familiarity with.
