Behavioral Finance Definition Theory Biases And Examples

Behavioral Finance Definition

Its prominence was reflected when traditional finance theories failed to explain many economic events like stock market bubbles in the United States. The two main ingredients of the study are cognitive psychology describing how people behave and the limits to arbitrage, explaining the level of effectiveness or ineffectiveness of arbitrage forces in various circumstances.

Behavioral Finance Theory Explained

Behavioral finance explores how factors like psychological influences and biases distort the logical reasoning of people. An environment with well-informed investors following rational decisions is always an important constituent for sustainable financial marketFinancial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more practices, but different concepts like bounded rationality restrict it from happening.

Key Takeaways

Behavioral finance is the study of understanding people’s irrational financial decisions.The two main building blocks are cognitive psychology and the limits to arbitrage.Some of the biases affecting financial decisions are confirmation bias, disposition bias, experiential bias, familiarity bias, loss aversion, mental accounting, and overconfidence.Understanding the psychological bias influence can help investors understand the market behavior and make better investment decisions.Businesses using the combination of traditional and behavioral finance theories to generate effective client management strategies are increasing.

Traders rely greatly on technical indicatorsTechnical IndicatorsTechnical indicators refer to technical analysis tools used by investors to make investment decisions based on future price movements derived primarily from historical prices. read more. However, in many cases, it has been noted that investors’ behavior in markets is often strange since it may be the opposite of what the technical market indicators may point to. The goals of any investor are to make profits from a market, and the decisions they make to achieve this may not always be rational.

The two main constituents, cognitive psychology and the limits to arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security’s price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more, can interpret diverse market scenarios where the influence of human psychology in financial decisions occurs. Therefore, understanding cognitive bias like overconfidence, herd mentalityHerd MentalityHerd Mentality is a concept where individuals adopt the ideology of a larger group bypassing personal critics and rationality. read more, and loss aversionLoss AversionLoss Aversion Bias is a cognitive phenomena in which a person is affected more by the loss than by the gain, i.e., in economic terms, the fear of losing money is greater than the amount that may be lost, therefore a bias exists to averse the loss first.read more is beneficial. Furthermore, the forces of arbitrage may fail, and this limit to the arbitrage process contributes to the persistence of financial market anomalies. Altogether the study explains the investor’s irrational decisions and discloses market behavior. However, the problem is that the behaviors of investors combined with their different biases make them difficult to predict.

Biases of Behavioral Finance

Biases play a major role in an entity’s financial decision-making process. Let’s look into a brief description of a few common biases:

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Confirmation bias: The confirmation biasConfirmation BiasConfirmation Bias is a cognitive bias type which refers to noticing, emphasizing, & favouring information that confirms our existing opinions & beliefs. In finance, investors would only process the data that fosters their hypotheses while ignoring all the contrary predictions. read more occurs when the investors align to the information that matches with their beliefs. The data could be wrong, but as long as it fits with their views, they end up relying on it. Experiential bias: It occurs when an investor’s memories or experiences from past events make them choose sides even when such a decision is not rational. For instance, previous or current bad experience leads them to avoid similar positions.Loss aversion: Loss aversion makes investors avoid taking a risk even if it earns high returns. They give priority to restraining from experiencing losses rather than experiencing high returns. Overconfidence: Overconfidence reflects when investors overestimate their abilities or trading skills and make decisions forgoing factual evidences.Disposition bias: It explains the propensity of investors to hold on to the stocks even if the prices are declining, believing that the prices will appreciate in the future and, at the same time, sell the well-performing stocks. Such investors tend to hold on to a stock losing money, hoping that the price will soon increase. In their minds, it’s only a matter of time before the tides change for them, and they can then make profits on all their positions in a market.Familiarity bias: The familiarity bias is reflected when investors place their investment in the stocks from the industry they know and understand rather than going after securities from an unrelated field. In this process, they may lose new or innovative opportunities that are revolutionary.Mental accounting: People’s budgeting process or spending habits may vary based on circumstances. That is, they don’t maintain a consistent pace. For instance, people may spend for luxury in a mall or while on vacation, and they also possess a modest lifestyle at home or when they are back from vacation.

Many academics have portrayed various biases, classifications, and how the human brain functions in irrational ways. It is evident in many behavioral finance booksBehavioral Finance BooksThe article contains the list of best 10 books on behavioral finance. Some of these books are Predictably Irrational, Thinking, Fast & Slow, The Little Book of Behavioral Economics, Inefficient Markets etc.read more and behavioral finance journals, which helps researchers understand the impact of human psychology in the financial decision-making process.

Practical Examples of Behavioral Finance

For a better understanding, let’s look into the following examples from the stock market scenario.

An investor in the stock market may opt-out because of the financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more affecting the stock market, thinking that the problem will take longer to resolve and recur in the future. If an individual has an experiential bias, the thought of a past crisis may make them see investing in stocks as a bad idea, even if all the evidence points to the opposite. They may then decide to invest in less profitable endeavors. Many investors are driven by herding behavior to join the bandwagon to invest in meme stocksMeme StocksMeme stocks attract retail investors through social media debates, leading to a surge in prices and trading volumes.read more like AMC and Gamestop ignoring risk factors.

The relevance of psychology in financial planningFinancial PlanningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process.read more is increasing. Financial advisors combine traditional concepts with elements of behavioral finance theory while developing strategies to strengthen the client relationship.