Behavioral Finance

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What Is Behavioral Finance?

Behavioral finance, a sub-field 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 explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price. 1:38

Behavioral Finance

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 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.

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.

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.

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 a confidence in self-based knowledge. Self-attribution usually stems from intrinsic confidence of a particular area. Within this category, individuals tend to rank their knowledge higher than others.

Biases Studied in Behavioral Finance

Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis, including:

Disposition Bias

Disposition bias refers to 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.

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 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 on 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.

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 with or have familiarity.

Behavioral Finance in the Stock Market

The efficient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality.

The EMH is generally based on the belief that market participants view stock prices rationally based on all current and future intrinsic and external factors. When studying the stock market, behavioral finance takes the view that markets are not fully efficient. This allows for observation of how psychological factors can influence the buying and selling of stocks.

The understanding and usage of behavioral finance biases is applied to stock and other trading market movements on a daily basis. Broadly, behavioral finance theories have also been used to provide clearer explanations of substantial market anomalies like bubbles and deep recessions. While not a part of EMH, investors and portfolio managers have a vested interest in understanding behavioral finance trends. These trends can be used to help analyze market price levels and fluctuations for speculation as well as decision-making purposes. 

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