behavioral-finance

What is Behavioral Finance? The Behavioral Finance Guide For Beginners

Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

The Flaws of Standard Finance and the Rise of The “Behavioral Crew”

In the first half of the twenty century, a group of economists believed that markets overall worked efficiently. In other words, we could assume by looking at the price of the assets exchanged through the stock exchanges that those prices were fairly valued.

This leads to the development of investment strategies, mainly based on the Modern Portfolio Theory (MPT), of which Harry Markowitz, of the University of Chicago, was the prophet. In short, the MPT developed a financial toolbox that presumingly would give the investor the maximum return, based on the assumed risk the investor undertook.

This led to the overconfident use of standard deviation and Beta, to assess the expected return of a certain stock. Although this method is flawed, it is still used by many financial institutions and professionals.

Economists slowly understood that in order to create a valid framework for investing a new approach was needed. Indeed, the understanding of the “psychology of the masses” was already known at the beginning of the twenty century (see Selden’s 1912 book “Psychology Of The Stock Market“).

On the other hand, this understanding was not packaged into the financial decision framework, because the “Chicago crew” was still too powerful. But the severe crises that happened in the last decades convinced economists and practitioners that the “new science” (behavioral finance) could not be ignored.

The “Behavioral Investor”

The rise of the efficient market theory survived throughout the twenty-century. On the other hand, recent studies have confirmed the importance of understanding the “psychological and sociological framework” before picking up stocks.

Therefore, the modern investor has to have a foundation in psychology and sociology as well. Why? For two main reasons:

  1. First, as Shefrin stated: “One investor’s mistakes can become another investor’s profits.” in other words, creating a financial model that incorporates the new discoveries of behavioral finance would more credibly fit reality.
  2. Second, one of the major causes of troubles in finance is due to overconfidence. The most striking aspect is that overconfidence affects academics and practitioners, more than the average guy.

Make Inaction Your Ally – the Overconfidence Paradox

Finance is one of those fields, in which experience and knowledge may create more harm than good. And the paradox is that hundreds of millions of individuals rely on the ability of fund managers to safeguard their savings.

What are the main behaviors we have to safeguard ourselves from?

As the say goes, “who dares wins.” No doubt that this “say” may work in some fields, such as entrepreneurship. On the other hand, when it comes to financing and investing it is important to take two variables into accounts: the opportunity cost and the transactional costs.

In other words, before buying and selling any stock, it is important to understand that when our money is tied to a financial instrument, we cannot invest it in an alternative one. In economics, this is called opportunity cost.

In addition, modern technologies allow us to buy and sell with a high frequency. This creates the illusion of low if not irrelevant transactional costs. But this is only an illusion. Why? For instance, in a study about how men and women invested, men resulted in more overconfident. Therefore, they traded with more frequency. The sudden increase in transactional costs, due to the impulse of men to act, slowly eroded the returns of those investors.

Surprisingly enough, transactional costs reduced men’s investment return by about 2.5%, compared to 1.72% for women. This may seem a small percentage but it is actually a 45% increase in transactional costs, which compounded for a few years, makes a huge difference. One way to avoid this is to set-up a long-term plan and make sure to stick with it.

Switch off Your Narrative Machine

Mr. Average has bought Popular Inc. stocks, based on the article he recently read in the Wall Street Journal. The article argued how the company that now produced the coolest socks in the world, was an amazing investment, due to their new acquisition. It all made sense in Mr. Average’s mind.

On the other hand, after a few days, the stock declined considerably. Did Mr. Average sell? Of course, he didn’t. In fact, he felt relieved when the news confirmed this only was a temporary adjustment. Unfortunately, it was not.

Yet even after losing more than half of the invested capital, Mr. Average still believed his investment was sound, and eventually, he would have profited. Why? He forgot to switch off his narrative machine.

In fact, modern psychologists argue that our conscious brain often intervenes after the fact. In short, if we are swept by our emotions, the unconscious mind decides for us. The conscious mind only intrudes to generate an ex-post narrative, which gives us the illusion that everything is under control. But this is only an illusion! Behavioral finance calls this phenomenon, “cognitive financial dissonance.”

Probability Neglect – Careful to the Sure Gain

Probably due to our biological heritage, we love sure things. Mr. Hominidus, while hunting in the Savannah, when given the chance to have a sure prey he could not resist the temptation. Why resist?

It was crucial for him to survive. Unfortunately, what worked in Savannah, does not work nowadays. In a complex world, in which rhythm is imposed by the probabilistic laws, Mr. Hominidus (which is us) makes a lot of bad decisions. In behavioral finance, this is called Prospect Theory.

Its assumptions are diametrically opposed to that of efficient market theory. In fact, prospect theory holds that “under the condition of uncertainty individuals act irrationally.” In other words, they neglect probabilistic laws altogether, which makes them very bad decision-makers.

How to Get out from the Savannah

As we saw many of our human features, evolved when we still lived in the Savannah. Now cultures and societies evolve at such a fast pace, that we are not able to keep up with them. How can we become better investors? Victor Ricciardi and Helen K. Simon give us some advice:

“The best way for investors to control their “mental mistakes” is to focus On a specific investment strategy over the long-term. Investors should keep detailed records outlining such matters as why a specific stock was purchased for their portfolio. Also, investors should decide upon specific criteria for making an investment decision to buy, sell or hold.”

To read the entire paper click here.

The limits of Behavioral Finance And Economics

While Behavioral Finance might represent an improvement of classical finance and economics, in reality, it showed already its many drawbacks. Indeed, the foundation of behavioral finance is built on the premise that:

  • Individuals are more often than not biased.
  • By understanding individual biases it’s possible to predict/tweak collective behaviors. 
  • That same complex models are relevant in the same way to predict the behaviors of individual/masses.

Those are just some of the flawed premises of behavioral finance. 

Indeed, as explained in bounded rationality, heuristics, and biases, which in many cases psychologists call biases, are context-based decision-making tricks. In addition, individual behaviors when scaled become something else, which cannot be explained from the individual but it becomes a creature of its own (to say the psychology of the individual is something completely different from that of the masses and confusing the two is extremely dangerous).

Lastly, behavioral finance has given the rise of the school of thought, that of the “nudgers” that believe that by understanding individual biases they can tweak the whole collective. 

This whole discipline, therefore, just as classic economics is flawed, and as an entrepreneur and business person you want to be skeptical of that. 

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

profitability
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: HeuristicsBiases.

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