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It would be nice for investors and markets to move solely on the basis of fundamentals, economics, and financial analysis of companies. But sometimes, investors seem to lack self-control, act irrationally, and make decisions based more on personal bias than fact.
The study of such psychological influences on investors, and by extension the markets, is called behavioral finance.
What is behavioral finance?
Behavioral finance arguably arose as a way to rationally explain irrational behavior by markets and investors or, as one acclaimed economist put it, finance from a broader social science perspective, including psychology. and sociology.
Traditional financial theory holds that markets and investors are rational; investors have perfect self-control and are not confused by cognitive errors or information processing errors.
Now, according to the Institute of Corporate Finance, behavioral finance holds that investors see themselves as “normal,” not “rational”; they have limits in their self-control, are influenced by their own biases, and make cognitive errors that can lead to wrong decisions.
The study of behavioral finance, a subfield of behavioral economics, emerged in the 1980s, when cracks began to appear in what was then considered the Efficient Market Hypothesis.
What does Behavioral Finance say about the efficient market hypothesis?
The Efficient Market Hypothesis, or EMH, was an investment theory that held that stock prices reflect all information about a particular investment or market at all times, so investors cannot buy undervalued stocks or sell stocks. at inflated prices. Excessive risk-adjusted returns, called alpha, cannot be EMH-consistent, meaning that only insider information can generate outsized risk-adjusted returns.
But if the EMH were a given, it would be impossible to outperform the overall market, even with expert stock picking or market timing. The only way an investor could beat the market would be to buy riskier investments. Because of this, those who have faith in EMH say there is no point in looking for undervalued stocks or trying to predict market trends through fundamental or technical analysis.
And investors like Warren Buffett have challenged EMH by consistently beating the market or outperforming for long periods of time, which would be impossible.
As evidence that stock prices can deviate from their fair values, EMH critics point to events like the 1987 stock market crash, when the Dow Jones Industrial Average lost more than 20% in a single day.
Economist and Yale scholar Robert J. Shiller, who won the Nobel Prize in Economic Sciences in 2013, explained in an article published in the Journal of Economic Perspectives in 2003 titled “From the theory of efficient markets to behavioral finance” that “Academic finance has come a long way since the days when the theory of efficient markets was widely considered to be proven beyond doubt.”
EMH’s heyday was in the 1970s, Shiller noted.
In the 1970s, some anomalies, such as slight serial dependencies in stock returns, began to show up as cracks in the efficient markets hypothesis.
He also noted that faith in EMH had been eroded by “a succession of anomaly discoveries, many in the 1980s” and, in particular, evidence of excess return volatility.
But it was in the 1980s that the “anomaly represented by the notion of excess volatility” began to cause deep fissures in adherence to the theory, even larger than the so-called “January effect” or the “day of the week effect”. .
“The evidence on excess volatility seems… to imply that price changes occur for no fundamental reason, that they occur due to ‘sunspots’ or ‘animal spirits’ or simply crowd psychology,” Shiller wrote.
Thus, in the 1990s, behavioral finance research was born.
“Indeed,” Shiller wrote, “we must move away from the assumption that financial markets always work well and that price changes always reflect genuine information.”
Shiller, writing after the so-called dotcom boom and subsequent bust, noted that the speculative bubble “had its origin in human foibles and arbitrary feedback relationships and must have generated real and substantial misallocation of resources.”
What are some key behavioral finance concepts?
There are four main concepts for behavioral finance.
- Mind Accounting: The propensity to allocate money for specific purposes.
- Herd behavior: The habit of people to imitate the financial behavior of the majority.
- Anchorage:Linking a level of spending to an easy benchmark, such as spending the most money on a popular brand of anything.
- High self-assessment: The tendency of individuals to rank higher than the average individual.
What are some examples of behavioral finance?
Here are a couple of examples of behavioral finance in action.
A lawsuit is filed against a company. Investors know from past experiences with the company that news of the lawsuit is likely to send the company’s stock price down. Many investors sell their stakes in the company, causing a further decline in the value of the asset. Investors in other companies in the same industry then fear lawsuits, knowing that a lawsuit has been filed against a similar company. Those investors sell their shares. The share prices of other companies in the same industry also fall. But neither company has taken any action or had a lawsuit against it. There hasn’t been any tangible reason for the stock price to fall.
Another example of herd behavior is the Google Stocks dashboard. Some investors, unaware of their own biases, may prefer to invest in alphabetical order, such as choosing a contractor based on “AAA” on the phone list. There’s a reason, for example, why Apple Inc.’s stock indicator is AAPL. And Google what? Google changed its name to Alphabet in 2015, being the umbrella under which Google operates.
Why is behavioral finance important?
Being aware of the precepts of behavioral finance can help investors test their perceptions against the facts. A classic example is anchoring. This is when an investor anchors at the price level of a previous portfolio security and constantly compares the previous, often higher, value with the current value, without taking into account changes in the market or even the outlook.
An investor may also lock in the price paid for a particular security by refusing to sell it despite poor performance in the hope of at least breaking even rather than suffering a loss without carefully evaluating the reasons behind its loss in value. .
Grazing is another behavior that you should be aware of and try to avoid in your own investing. Herding is demonstrated in exactly the same way you would think: by following the crowd. This is how less sophisticated investors often get into trouble. If “everyone” is buying a particular security, without investigating why, other than the fact that its price is rising (because people are buying it), investors often jump in because they don’t want to “miss the boat.” This is exactly how stock and market “bubbles” form. Herding can cause an investor to purchase investments that may not be appropriate for their financial goals or risk tolerance.
The opposite also is true. When, for example, a stock index begins to fall, investors often want to liquidate their holdings, even in mutual funds, to avoid losses. But a smart investor can tell you that often individual stocks and markets rise until those who want to buy do, and fall when some big investors sell. The reasons behind the move should be examined before following the herd, ie any information available about the company or the market other than “is it going up” or “is it going down”. Big smart investors often sell after a rally to make a profit.
A high self-assessment can also be considered overconfidence. This behavior also often gets investors into trouble because it is based on the belief that you are smarter or more capable than you really are, for example, at spotting the next investment trend or hot stock. An overconfident trader is often seen trading more frequently than others, believing that he has better information than others. Frequent trading often leads to below par portfolio performance, caused by increased fees, taxes and losses.
So, you see, being aware of behavioral investing—your own and that of others—can help you save money and look more carefully before jumping into a position.
