Behavioral Finance
“Economic conditions may differ from period to
period, but human psychology is embedded
among us and will not change”
Let us visualize the stock market as a person: It has mood swings (and price fluctuations) that may range from irritated to ecstatic in an instant; it can overreact impulsively one day and make amends the next. But, does human behavior truly assist us in understanding financial matters? Does studying the market mood help us with any practical strategies? According to behavioral finance theorists, it does.
Behavioral finance is founded on the alternative premise that investors are vulnerable to behavioral biases that lead to less-than-perfect rational financial decisions.
This concept attempts to explain and improve knowledge of investors’ thinking patterns, including the emotional processes involved and the extent to which they impact decision-making. It seeks to explain the what, why, and how of finance and investing from a human standpoint.
THE THIN LINE BETWEEN TRADITIONAL AND BEHAVIORAL FINANCE
Before delving deep into the world of behavioral finance, we must first understand the basic differences between traditional and behavioral financial theories.
Behavioral Finance attempts to analyze how investors’ decision-making processes are affected by their cognitive errors or mental errors and emotions. Investors are often irrational and biased, and the opposite in quantitative models of traditional financial theories. Knowledge of these biases makes it easy for investors to realize their own mistakes to ensure that such mistakes are not made in the future, but standard financial theory, on the other hand, assumes in its models that people are rational actors, free from emotions or the influences of culture and social relations, and that people are self-interested utility maximizers. Further, it assumes that markets are efficient and that firms are rational profit-maximizing organizations. Behavioral finance challenges each of these assumptions.
Behavioral biases have the capacity to influence the actions and decisions of financial market participants. Understanding behavioral biases is critical in today’s financial environment, therefore let’s look at some instances of behavioral biases and their respective investor psychology :
IS IT PREFERABLE TO FIND $5 OR NOT LOSE $5?
Every investor’s ability to take risks is different. Some are conservative in their approach, while others believe in taking calculated risks. However, there are few among conservative investors who fear losses greatly. They may be aware of the potential gains from an asset class, but fear the possibility of a short-term loss. Therefore, their enthusiasm for winning is far less than their reluctance to lose, and this is referred to as the concept of loss aversion. Thus, it is preferable to not lose $5 rather than finding $5.
“COLLECTIVE FEAR STIMULATES HERD INSTINCT, AND TENDS TO PRODUCE FEROCITY TOWARD THOSE WHO ARE NOT REGARDED AS MEMBERS OF THE HERD”
The tendency for people to emulate the habits or actions of a bigger sized group is referred to as herd mentality. The reason for this is societal pressure to comply as well as the widely held belief that a huge group cannot be wrong. Several companies had financially unsound business models during the dotcom bubble, yet many investors bought them because everyone else did. Be it the subprime crisis in 2008, the eurozone crisis in 2010 or the recent banking sector scam in India, the market has seen huge sales, many of which aren’t even guaranteed.
“IF YOU’VE EVER HELD ON TO A PAIR OF SHOES THAT MAKE YOUR FEET ACHE OR A PAIR OF PANTS THAT NO LONGER FIT YOU FOR NO OTHER REASON THAN YOU PAID A LOT OF MONEY FOR THEM, YOU’VE EXPERIENCED THE SUNK-COST BIAS”
A sunk cost is a cost that has already been incurred and cannot be recovered in the future.The term sunk cost fallacy is used to describe a situation where individuals continue to engage in a particular pattern of behavior because they have previously committed resources (time, money, effort). If the costs surpass the benefits, the additional costs (inconvenience, time, and money) are recorded in a different cognitive statement than the one linked with the transaction.
The above image depicts the gambler’s fallacy which is the perception of patterns where none exist. People frequently try to impose order on situations that are in fact random.This phenomenon is named after gamblers who assume that good luck will follow after a series of bad luck at a casino.
The human mind looks for patterns and is fast to detect causality in occurrences. It arises when a person believes that a particular outcome is “deserved,” notwithstanding a process’s statistical independence. In the context of investing, this bias might lend unjustified legitimacy to the assertions of fund managers who have been successful for a few years in a row.
“EMOTION CAN BE THE ENEMY, IF YOU GIVE INTO YOUR EMOTION, YOU WILL LOSE YOURSELF”
Most behavioral anomalies are caused by excessive emotions from investors. This happens when investors do not make decisions with an objective mind and tend to only respond to their biases. Misconceptions, misinterpretations, risk aversion, and past experiences all combine to hinder a rational inclination of the mind and expose investment decisions to the possibility of risk and loss.
“FRAMING EFFECTS CAN BE VERY INFLUENTIAL, AND TO THE DEGREE THAT YOU CAN THINK OF A TASK AS CLOSE RATHER THAN DISTANT, YOU’RE MORE LIKELY TO ACTUALLY GET IT DONE.”
According to Modern Portfolio Theory, an investment cannot be valued in isolation, it should be seen in the light of the entire portfolio. Investors should have a broader vision of wealth management rather than focusing on individual securities. However, there are investors who choose assets for consideration, which is to look at things from a “narrow perspective” which leads to losses. Investors need to look at the holistic picture and evaluate it with a broader mindset.
Oftentimes, investors hold on to a certain belief and refuse to part ways with it. They attach their beliefs to these concepts and have trouble accepting any new information on the subject. Anchoring bias can manifest itself in a variety of ways in the realm of investment. Traders, for example, are often tied to the price at which they purchased a security. If a trader purchased stock ABC for $100, they will be psychologically fixated on that price when deciding when to sell or buy more of the same stock.
CONCLUSION
Behavioral finance is not just a part of finance, its scope is broader and it includes insights from behavioral economics, psychology and microeconomic theory. This theory loosens the rationality assumption present in standard financial theories and tells us that investors are affected by their psychological biases.
Behavioral finance has grown to be a highly respected discipline. Many of its supporters anticipate that in the next few years, behavioral finance will become so ingrained in mainstream economics and business that the difference will no longer be necessary. Since the economic worldview of rational actors can no longer be upheld, true advancement in the study of economics requires the incorporation of research findings from the behavioral and psychological disciplines. The exact definition of behavioral finance is still a matter of debate but it would be correct to say that it is an evolutionary concept and it keeps evolving with time.
Curated By: Abhay Daga and Yash Jain
(Abhay Daga is a 1st year student pursuing B.Com(H) at St. Xavier’s College (Autonomous), Kolkata and a Research Analyst of the Xavier’s Finance Community.)
(Yash Jain is a 1st year student pursuing B.Com(H) at St. Xavier’s College (Autonomous), Kolkata and a Research Analyst of the Xavier’s Finance Community.)