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 assumes that people always make rational choices based on optimizing their outcomes, void of context.
Aspect
Explanation
Concept Overview
Behavioral Finance is an interdisciplinary field that combines insights from psychology and economics to understand how human behavior and cognitive biases influence financial decision-making. It challenges the traditional assumption of rationality in economic models, recognizing that individuals often make financial choices that deviate from what traditional economic theories predict. Behavioral Finance seeks to identify and explain these deviations, shedding light on why people make certain financial decisions, even when those decisions might not be in their best financial interest.
Key Principles
Behavioral Finance is guided by several key principles: 1. Bounded Rationality: Recognizing that individuals have limited cognitive abilities and information-processing capacities, which can lead to systematic errors in judgment and decision-making. 2. Psychological Biases: Acknowledging that cognitive biases, such as overconfidence, loss aversion, and framing effects, influence financial decisions. 3. Emotional Factors: Understanding that emotions, such as fear and greed, can drive financial behaviors and market dynamics. 4. Prospect Theory: Embracing the concept of Prospect Theory, which suggests that people tend to evaluate potential gains and losses in a subjective and non-linear manner. 5. Herding Behavior: Examining the tendency of individuals to follow the crowd or mimic the behavior of others in financial markets. 6. Market Anomalies: Identifying market anomalies or patterns that defy traditional financial theories. 7. Adaptive Market Hypothesis: Considering the idea that market participants adapt and learn over time, impacting market dynamics.
Behavioral Biases
Behavioral Finance identifies various biases that affect financial decision-making: 1. Confirmation Bias: The tendency to seek out and give more weight to information that confirms existing beliefs. 2. Anchoring: The reliance on initial information or “anchors” when making decisions, even if that information is irrelevant. 3. Loss Aversion: The preference for avoiding losses over acquiring equivalent gains, leading to risk-averse behavior. 4. Availability Heuristic: Giving more weight to readily available or recent information when making decisions. 5. Overconfidence: Overestimating one’s knowledge or abilities, leading to excessive trading and risk-taking. 6. Framing Effect: Making different decisions based on how information is presented or framed. 7. Herding Behavior: Following the actions of others in the belief that they possess superior information.
Applications
Behavioral Finance has practical applications in various areas: 1. Investment Decisions: Understanding how investor behavior is influenced by emotions and cognitive biases can inform investment strategies. 2. Retirement Planning: Recognizing how individuals perceive risk and make long-term financial decisions is crucial for retirement planning. 3. Market Regulation: Insights from Behavioral Finance can inform regulatory efforts aimed at reducing market anomalies and excessive risk-taking. 4. Behavioral Economics: Integrating behavioral insights into public policy, such as nudging individuals toward beneficial financial behaviors. 5. Financial Education: Improving financial literacy by teaching individuals to recognize and mitigate cognitive biases in decision-making.
Benefits and Impact
Behavioral Finance offers several benefits and impacts: 1. Realistic Models: Provides a more realistic and accurate understanding of financial decision-making compared to traditional economic models. 2. Risk Management: Helps investors and financial professionals better manage risk by accounting for behavioral biases. 3. Market Efficiency: Encourages a more nuanced view of market efficiency, recognizing that markets can be influenced by behavioral factors. 4. Improved Decision-Making: Enhances individual decision-making by promoting awareness of cognitive biases. 5. Investment Strategies: Supports the development of investment strategies that consider both rational and irrational aspects of markets.
Challenges and Critiques
Challenges in Behavioral Finance include criticisms of its subjectivity and the difficulty of consistently predicting behavior. Critics also argue that behavioral biases can be overemphasized, and individuals can learn to mitigate them. However, proponents maintain that understanding and accounting for these biases remains valuable in financial analysis and decision-making.
Table of Contents
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:
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.
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.”
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.
Case Studies
1. Overconfidence Bias in Investment:
Scenario: Many investors exhibit overconfidence bias, believing they have superior knowledge and abilities in selecting stocks. They frequently trade, leading to higher transaction costs and lower returns.
Implications: Research shows that overconfident investors often underperform the market due to excessive trading and poor portfolio diversification.
2. Herd Behavior During Market Bubbles:
Scenario: During the dot-com bubble of the late 1990s and the housing market bubble of the mid-2000s, investors exhibited herd behavior, buying into assets because others were doing so, leading to inflated prices.
Implications: Bubbles eventually burst, causing significant market crashes and losses for those who followed the herd without conducting proper due diligence.
3. Loss Aversion and Portfolio Management:
Scenario: Loss aversion is the tendency for individuals to feel the pain of losses more acutely than the pleasure of gains. Investors may hold onto losing investments for too long to avoid realizing losses.
Implications: Behavioral finance research suggests that loss aversion can lead to suboptimal portfolio management and reduced returns.
4. Mental Accounting in Spending Habits:
Scenario: People often engage in mental accounting, segregating their money into different mental “buckets” with varying spending rules. For example, individuals might spend a tax refund differently from a regular paycheck.
Implications: Behavioral economists have shown that mental accounting can lead to suboptimal spending decisions and inefficient use of resources.
5. Confirmation Bias in Stock Research:
Scenario: Investors may exhibit confirmation bias by seeking out information that supports their existing beliefs about a stock while ignoring or discounting contradictory information.
Implications: Confirmation bias can lead to flawed investment decisions and a failure to objectively evaluate the risks associated with a particular investment.
6. Prospect Theory and Decision-Making:
Scenario: Prospect theory suggests that individuals weigh potential gains and losses differently when making decisions. For example, they may be risk-averse when facing potential gains but risk-seeking when facing potential losses.
Implications: Understanding prospect theory helps explain why investors often make decisions that do not align with traditional economic models of rational behavior.
Key Highlights
Introduction to Behavioral Finance: Behavioral finance explores how psychological factors and biases influence individual decision-making and how those decisions collectively affect markets and economies. It challenges the assumption of classical finance that people always make rational choices.
Flaws in Standard Finance: Earlier economists believed in market efficiency, assuming that market prices accurately reflect asset values. This led to investment strategies based on the Modern Portfolio Theory (MPT). However, these methods, such as using standard deviation and Beta, had flaws and were not comprehensive enough.
Rise of Behavioral Finance: As financial crises occurred, economists realized that behavioral factors couldn’t be ignored. Insights into the psychology of investors were present in the early 20th century, but they were not integrated into financial decision-making frameworks.
The “Behavioral Investor”: Modern investors need to understand psychology and sociology alongside traditional finance. Behavioral finance offers insights into understanding human behavior, which can lead to better financial models.
Overconfidence Paradox: Overconfidence is a behavior that affects both academics and practitioners in finance. It can lead to excessive trading, increasing transactional costs, and eroding returns.
Opportunity Cost and Transactional Costs: Investors must consider opportunity costs before buying and selling stocks. Additionally, the illusion of low transactional costs due to high-frequency trading can be detrimental.
Switch off Your Narrative Machine: Investors often hold onto narratives that led to their investment decisions, even when faced with losses. This is due to cognitive financial dissonance, where the unconscious mind decides based on emotions.
Probability Neglect: Humans are drawn to sure gains, ignoring probabilistic outcomes. Prospect Theory in behavioral finance suggests that people often act irrationally under uncertainty.
Getting Out from the Savannah: Our evolutionary tendencies might not be suitable for complex modern decision-making. The key to better investment decisions is focusing on a specific long-term strategy and maintaining detailed records of investment decisions.
Limits of Behavioral Finance:
Behavioral finance is an improvement over classical finance but has its flaws.
It assumes individuals are biased and that understanding these biases can predict collective behavior.
It overgeneralizes complex models to predict the behavior of individuals and masses.
The discipline has been criticized for conflating individual psychology with collective psychology.
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.
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.
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.
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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.
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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.
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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.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
