Behavioral finance is an aspect of financial markets worth learning about. Most investors assume they are making rational decisions when they are not. A wide range of biases can affect your decision making – without you being aware of it. Understanding the financial psychology that drives asset prices can also be useful when timing investments and managing risk. This post explores the biases and other behavioral factors that can affect your views and decisions. We also highlight some of the things you can do to avoid the mistakes biases can cause.
- What is behavioral finance?
- Traditional vs. behavioral finance
- Behavioral finance vs. behavioral economics
- Why is behavioral finance important?
- Behavioral biases and key concepts in behavioral finance
- Behavioral finance examples
- Advantages of behavioral finance
- Disadvantages of behavioral finance
- Investment strategies to avoid or take advantage of financial psychology
What is behavioral finance?
Investment theories tend to assume that people are rational decision makers. Reality is often very different, and decision making is influenced by emotion, biases, social factors and cognitive errors. Behavioral finance is a field that considers the decision making of normal rather than rational people. The field is gaining widespread prominence as an important aspect of financial analysis.
Traditional vs. behavioral finance
Much of the financial theory developed over the past seven decades treats investors as rational. This is in keeping with the broader field of economics which also considers decision makers as rational. Modern Portfolio Theory and the Efficient Market Hypothesis are the two most widely cited theories on traditional investing.
Both make a range of assumptions about investment decision making. Among these are the assumptions that investors seek to maximize returns and that investors are rational. Behavioral investing theory explores the fact that investors are not rational. It also considers various motivations investors have for making decisions. To an extent, it explains certain anomalies between financial models and real-world outcomes.
If you understand financial psychology, it will help you understand some flaws in traditional finance. You will also be more aware of your own cognitive biases and the mistakes you may make as an investor. The field of quantitative investing also attempts to incorporate real world outcomes, rather than theory in decision making.
Behavioral finance vs. behavioral economics
Behavioral finance is concerned with the way psychological and social factors affect decision making specifically in financial markets. Behavioral economics explores many of the same “non-rational” factors that can affect decision making. However, in this case their effect on a wider range on decisions is studied. This can include the way consumers and business leaders make decisions. It also includes game theory and evolutionary psychology.
These concepts can be used when studying or forecasting almost any economic metric from consumer spending and confidence, to debt, growth and unemployment. Furthermore, the term financial psychology is often used to refer to a slightly different topic. Financial psychology is often used in the broader field of personal finance. This includes saving, spending, debt, credit cards and insurance. Financial planners and advisors are as concerned with these factors as with investment decision making.
Why is behavioral finance important?
An understanding of financial psychology and behavioral finance can be an advantage in two respects. Firstly, understanding the different ways our decision-making process can be affected can help us avoid common traps in the stock market. Secondly, an understanding of the financial behaviors of other market participants can help us identify opportunities. The best time to enter new trades or make investments is when others are making mistakes.
Behavioral biases and key concepts in behavioral finance
Financial psychology revolves around a few key concepts. In practice a combination of these concepts can affect an investment decision. Cognitive Biases: A range of psychological biases are likely to affect decisions. There are over 50 of these, with about ten affecting investment decisions. The following are the most important of these:
- Confirmation bias causes investors to accept evidence that confirms their beliefs and discount information that doesn’t.
- The narrative fallacy bias causes investors to gravitate toward investments with a good story, even if they are overvalued.
- Anchoring bias is the tendency of people to use arbitrary numbers as a reference point on which to base opinions.
- Hindsight bias affects the way people perceive their own past predictions. Investors will often remember the predictions they get right rather than those they get wrong.
- Endowment bias occurs when assets that are owned are given more importance than those that aren’t.
- Recency bias causes investors to overemphasize recent events more than events in the distant past.
- Loss aversion bias occurs when investors avoid risks because they view potential gains and losses differently.
- Attribution bias occurs when investors attribute different outcomes to different causes. Winning trades may be ascribed to skill, while losing trades are ascribed to market manipulation.
Herding: Market participants are more likely to follow the behavior of others than to follow their own path. Herding is one of the reasons for bubbles and is the reason momentum can be a successful investment strategy. Even professional analysts are likely to “follow the herd” to avoid standing out as wrong.
Mental accounting: Investors and consumers frequently assign different values to money according to its source. Money that is earned will be spent more carefully than money that is inherited, won or received as gift. For example, tax rebates are likely to be spent. If the amount had not been paid as tax, it would probably have been saved.
Regret avoidance: Investors will often stick with losing stocks to avoid the regret that would come with acknowledging their mistake and selling the stock. Regret avoidance is like the sunk cost fallacy where business managers continue to invest in unprofitable products rather than admitting failure.
Misunderstanding of probability: The concepts of probability and possibility are often confused. Investors often bet on an outcome since it is possible. A possible outcome can have a very low probability of occurring.
Behavioral finance examples
The following are real world examples of some of the most common behavioral biases. As you will see, several biases can occur at the same time.
- Narrative fallacy
- Confirmation bias
- Endowment bias
- Anchoring bias
- Mental accounting
- Probability vs. possibility
A frequent example of herd behavior occurs with ETF investing. Investors often gravitate to ETFs in “hot” sectors, or to funds that have recently performed well. This initially causes the fund to perform well. Eventually though, the price stops rising. Investors then find there are no buyers and the price collapses.
A well-known phenomenon occurs in the mutual fund industry. Many investors underperform the funds they invest in. This happens because they invest after periods of good performance and withdraw money after periods of underperformance. In this case they are using returns to guide their actions. Those returns are based on the behavior of others.
Over the last decade we have witnessed a series of bubbles forming in investments that had good stories, despite valuations being irrational. The first was stocks of 3D printing companies. These stocks appreciated as much as 1000% in less than a year. The next was cryptocurrencies in 2017.
Most recently it was cannabis companies ahead of legalization of cannabis in Canada. In all these cases, the story was compelling. However, no matter how compelling the story is, there is a limit to the value of a company. These bubbles are driven by speculative money. They burst when the speculative money runs out.
Confirmation bias is often displayed by permabulls and permabears. Permabulls will discount bearish information and use bullish information to support their view. Permabears do exactly the opposite. Some market pundits are either permanently bullish or permanently bearish. Their analysis is of little value as nothing will change their view.
The endowment bias often occurs when investors do well with a particular stock. The same can apply to a sector or style of investing. In the years before 2008, many people made money with value stocks. After 2008 they stayed with the same types of stocks, which went on to underperform. The same has happened recently with growth stocks. Many investors are sticking with underperforming growth stocks due to their past experience.
Imagine a stock rises 100% in a year and is trading at $50. Investors may then expect the stock to appreciate another 100% to reach $100. This view assumes the 100% gain and the $50 price were justified. It also assumes the 100% gain will be repeated.
Investors often wipe out years of bull market gains due to mental accounting. They view gains as money they can take more risk with. The problem is that they may still hold the original investments. So, they are risking paper profits on even riskier investments. The effects are magnified when leverage is used.
This can result in losses on the original trade as well as the additional trades. Mental accounting also results in individuals increasing their spending levels, based on their unrealized paper profits. If the profits are not realized, they have spent money they never actually earned.
Probability vs. possibility
Confusion between probabilities and possibilities occur often when it comes to stock market crash predictions. At any given moment there are valid reasons a crash is possible. But, taking that to mean a crash is likely or probable is a mistake. There are several ways to manage portfolio risk. But, betting on a specific black swan event will probably result in a loss. Over time these losses will create a drag on performance.
Advantages of behavioral finance
Financial psychology tends to be a disadvantage when it affects our own decision making. But it can be an advantage when we understand the way it affects other investors and the behavior of prices.
- Herding is possibly the most useful characteristic of markets for long term investors. It creates opportunities to buy stocks cheaply and sell stocks at inflated levels. Momentum trading also benefits from this phenomenon, provided risk is well managed.
- Cognitive biases can create opportunities for value investors who are prepared to do their homework. Investors will often refuse to face reality as a stock price begins to decline. Later, when they capitulate, the stock will trade well below fair value.
- Market sentiment and financial psychology are closely related. Sentiment is often the best way to track the effects of bias and emotion in the market. When combined with other models, sentiment can be used to identify profitable opportunities.
Disadvantages of behavioral finance
The negative side of behavioral finance is the way in which it can affect our own behavior. In practice this can happen along with emotional decision making. The likelihood of financial bias affecting our decisions increases during strong rallies and when volatility increases. Every type of bias can negatively affect decision making. Therefore, it is important to be aware of all these traits in human behavior.
Investment strategies that can help you avoid or take advantage of financial psychology
The best way to reduce the effects of financial bias on decision making is to assume that you have these biases. There are also a few investing strategies that can help you to avoid the traps that they create:
- One of the biggest advantages of passive investing is that it removes the opportunity to make mistakes when reacting to market events.
- Investing in illiquid assets also removes the opportunity to make irrational decisions. Usually low liquidity is a bad thing, but it can prevent impulsive behavior.
- Quantitative investing strategies are based on historical data and evidence. This data includes the effects of both traditional models and financial psychology. Factor investing is a stock picking strategy based on evidence and quantitative research.
- Value investing is contrarian by nature. In many cases it is a bet against prices created by the market’s biases.
- Ensuring broad asset allocation can also mitigate some of the effects of financial psychology. No matter how strongly you feel about an asset class, you should still have capital in other uncorrelated asset classes.
Conclusion: Be aware of the biases that affect investment decisions
There are two advantages to understanding behavioral finance. The first is that being aware of the biases that affect decisions can help prevent you from making mistakes. The second is that you can use the knowledge to your advantage. In the future, behavioral finance investing strategies that leverage machine learning and quantitative research may become a dominant force in fund management.