Behavioral Finance

Behavioral finance is the study of how individual psychology, including cognitive biases, affect the financial decisions of individuals.This field of study examines how psychological factors can lead to poor decisions that negatively impact wealth. The discipline applies to both personal financial decisions and personal and institutional investment decisions.

There are a lot of real-world examples supporting behavioral finance theory. For instance, when the U.S. stock market recorded its biggest one-day percentage drop during the Black Monday crisis in October 1987. Robert Shiller, a renowned economist, found it was due to investors’ expectations of an impending crash.

Behavioral finance theory aims to help understand financial choices and how these affect markets. It focuses on the role of personal biases when making financial decisions. Unlike traditional finance theory, behavioral finance states that individuals can be emotional and have limited self-control when it comes to their finances. However, they are able to assess these errors and biases which can help them make rational and informed financial decisions.

In studying behavioral finance, it is important to understand prospect theory. Originally conceived by Daniel Kahneman and Amos Tversky in 1979, this underlying theory describes how individuals view risk and reward.

For instance, a person is given $1,000. Then, they are asked to choose between a 50% chance of getting another $1,000 and 100% chance of getting $500. The study showed that more people will choose the latter option. However, if they are given $2,000 and are asked to choose between a 50% chance of losing $1,000 and a 100% chance of losing $500, they will choose the gamble.

The theory states that people value losses and gains differently. People tend to take the risk if there is a 50% chance of losing or giving up something, but they tend to choose options where they believe they will have a 100% chance of benefiting from the choice. One aspect of prospect theory is loss aversion theory, meaning people tend to view losses to be far worse than gains with a similar chance outcome. You can see this in the s-curve graph above. The loss of $500 is far greater than the gain of $500.

Here are some of its key concepts:

• Losses loom larger than gains which is referred to as loss aversion.
• Gains and losses are dependent on frame of reference.
• A result of this framework is that depending on the situation the same individual could be either risk-seeking or risk-averse.

The study of behavioral finance will provide you better insight on the concepts and biases that affect your decisions when it comes to your debts, payments, risks and investments. With this, you can assess your situation more rationally so that you allocate your finances wisely.

The primary effects observed in behavioral finance are:

• Anchoring Bias is the tendency to focus on a specific reference point in evaluating a situation or decision. As a component of prospect theory, anchoring can be responsible for risk-seeking and risk-averse strategies. Instead of evaluating a product based on its intrinsic value, an investor may only look at past investment performance rather than the current state of a product.
• Emotions can cause individuals to make decisions based on feelings instead of facts. When people make decisions based on emotions, they have a higher likelihood of making poor decisions or decisions they may regret later, compared to decisions they are certain of making if they were thinking logically.
• Herd Instinct is when people are influenced by the actions, beliefs and behaviors of others around them. Herd instinct can lead individuals to hasty decisions as they use the actions of others as a heuristic (a mental shortcut) for decision-making. For example, fear of missing out (FOMO) is a common example of individuals falling victim to herd behavior.
• Hyperbolic Discounting is the way people inconsistently weigh future benefits. It leads to regret and less-than-optimal decision-making. For example, a person prefers $100 today over $105 tomorrow, but does not prefer $100 in 30 days over having $105 in 31 days. Despite the fact that there is a one-day difference in payoffs for each scenario, the reference point of the reward in time changes the preferences of the individual.
• Mental Accounting is the way people mentally organize, evaluate and monitor their finances. A form of mental accounting is the practice of segregating gains and losses into different categories. Mental accounting can yield suboptimal decisions as investors are unable to see the large picture across these categories.
• Overconfidence (or Self-Attribution) is the tendency of people to overestimate their knowledge, underestimate risk, and overestimate their control of situations. The problem with overconfidence is that it makes a person less cautious when making investment decisions. You might view your investments as less risky than they really are.

Concept: Disposition Effect

Let’s say you buy a stock at $42 which then drops to $34 before rising to $39. Would you hold onto the stock in hopes of getting back to $42? Most people would. They would wait until it gets above $42, regardless of the underlying aspects of the company.

This anomaly is called the disposition effect, as coined by Hersh Shefrin and Meir Statman. The disposition effect is a combination of anchoring and mental accounting, wherein traders sell gaining stocks to realize their wins while they hold the losing stocks to avoid the emotional state of loss.

Concept: Herd Instinct

In June 2021, the world saw a Meme Stock explosion. It happened when a subset of traders drove up Bed Bath & Beyond (BBY) shares by 62%. The phenomenon is an example of how herd behavior and overconfidence can affect the marker. Investors drove shares not because the company beat earnings but due to an increase in demand because of the fear of missing out (FOMO) on trends.

Concept: Confirmation Bias

Have you ever seen an investor who cannot be swayed that their investment could perform poorly? Every bit of evidence seems to be ignored except for the pieces of information that support their position? This is an example of confirmation. In finance, confirmation bias can contribute to overconfidence in their decisions, investing or otherwise.

Concept: Hyperbolic Discounting

Cash is a more immediate form of payment where the loss of money is felt by an individual as it leaves their wallet. On the other hand, using credit cards can disguise losses. People tend to not immediately feel the “pain of paying,” so it is possible to overvalue what happens in the present (hyperbolic discounting). Because of this, some people underestimate how much they are spending and end up with high debts. It’s a good idea to look into how credit cards work and to use it wisely.

Concept: Anchoring Bias

Deals can play into the way people anchor prices and make decisions where they think they’re getting the best offer. Imagine you are buying auto insurance. As part of the purchase process, you are offered a coverage plan at $1,500. Your insurer gives you a safe driver discount of 10%. Now the total price comes out to be $1,350. You want to compare quotes with another car insurance provider. You find another insurance company, and your second insurer gives you the same offer of $1,350. Instead of a safe driver discount, you see, say, a charge for being a risky driver based on your driving history. By anchoring at the higher price of the risky driver, the first company creates a perception of an added benefit to create more sales.

Generally, there are two schools of thought when it comes to finance. The first one is behavioral finance. The second is traditional finance theory.

Traditional finance theory is the opposite of behavioral finance. It dismisses the idea that a person’s psychology can affect their financial decisions. It states that people act rationally and have unbiased expectations of the future. They base their investment decisions on data and information they have gathered or received.

Awareness of what behavioral finance is and how your psychology may affect finance and investment decision-making will help you become a more savvy investor and consumer. Knowing the biases that affect your decisions can help improve your financial capability. That is because you will be in a better position to make calculated moves when it comes to your money.

Take loss aversion for example. It is one of the most common cognitive biases. Because of this, you end up avoiding small risks even if they are probably going to give good returns. It is also among the reasons why some people choose saving over investment. Being aware of this bias will help you have a better view on wealth management. You can check up on your emotions and make a mental effort to take some risk by starting with assets that usually perform well.

Behavioral finance awareness will allow you to overcome personal biases. This way, you can make better and well-informed financial decisions.

Here are some ways to do that:

Understanding behavioral finance can be a bit difficult, especially if it is your first time encountering this theory. MoneyGeek answers some frequently asked questions to help you.