For decades, psychologists and sociologists have pushed back against the theories of mainstream finance and economics, arguing that human beings are not rational utility-maximizing actors and that markets are not efficient in the real world. The field of behavioral economics arose in the late 1970s to address these issues, accumulating a wide swath of cases when people systematically behave "irrationally." The application of behavioral economics to the world of finance is known, unsurprisingly, as behavioral finance.

From this perspective, it's not difficult to imagine the stock market as a person: It has mood swings (and price swings) that can turn on a dime from irritable to euphoric; it can overreact hastily one day and make amends the next. But can human behavior really help us understand financial matters? Does analyzing the mood of the market provide us with any hands-on strategies? Behavioral finance theorists suggest that it can.

Key Takeaways

  • Behavioral finance asserts that rather than being rational and calculating, people often make financial decisions based on emotions and cognitive biases.
  • For instance, investors often hold losing positions rather than feel the pain associated with taking a loss.
  • The instinct to move with the herd explains why investors buy in bull markets and sell in bear markets.
  • Behavioral finance is useful in analyzing market returns in hindsight, but has not yet produced any insights that can help investors develop a strategy that will outperform in the future.

Some Findings from Behavioral Finance

Behavioral finance is a subfield of behavioral economics, which argues that when making financial decisions like investing people are not nearly as rational as traditional finance theory predicts. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some interesting descriptions and explanations.

The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that financial markets are efficient. Proponents of the efficient market hypothesis (EMH), for instance, claim that any new information relevant to a company's value is quickly priced by the market. As a result, future price moves are random because all available (public and some non-public) information is already discounted in current values.

However, for anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviorists explain that, rather than being anomalies, irrational behavior is commonplace. In fact, researchers have regularly reproduced examples of irrational behavior outside of finance using very simple experiments.

The Importance of Losses Versus Significance of Gains

Here is one experiment: Offer someone a choice of a sure $50 or, on the flip of a coin, the possibility of winning $100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of 1) a sure loss of $50 or 2) on a flip of a coin, either a loss of $100 or nothing. The person, rather than accept a $50 loss, will probably pick the second option and flip the coin. This is known as loss aversion.

The chance of the coin landing on one side or the other is equivalent in any scenario, yet people will go for the coin toss to save themselves from a $50 loss even though the coin flip could mean an even greater loss of $100. That's because people tend to view the possibility of recouping a loss as more important than the possibility of greater gain.

The priority of avoiding losses also holds true for investors. Just think of Nortel Networks shareholders who watched their stock's value plummet from over $100 a share in early 2000 to less than $2 a few years later. No matter how low the price drops, investors—believing that the price will eventually come back—often hold stocks rather than suffer the pain of taking a loss.

The Herd vs. Self

The herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing.

Behavior finance has also found that investors tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock.

On the other hand, beliefs are not easily shaken. One notion that gripped investors through the late 1990s, for example, was that any sudden drop in the market is a buying opportunity. Indeed, this buy-the-dip view still pervades. Investors are often overconfident in their judgments and tend to pounce on a single "telling" detail rather than the more obvious average. In doing so, they fail to see the larger picture by focusing too much on smaller details.

How Practical Is Behavioral Finance?

We can ask ourselves if these studies will help investors beat the market. After all, rational shortcomings should provide plenty of profitable opportunities for wise investors. In practice, however, few if any value investors are deploying behavioral principles to sort out which cheap stocks actually offer returns that are consistently above the norm.

The impact of behavioral finance research still remains greater in academia than in practical money management. While theories point to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias.

Robert Shiller, the author of "Irrational Exuberance" (2000), showed that in the late 1990s, the market was in the thick of a bubble. But he couldn't say when the bubble would pop. Similarly, today's behaviorists can't tell us when the market has hit a top, just as they could not tell when it would bottom after the 2007-2008 financial crisis. They can, however, describe what an important turning point might look like.

Frequently Asked Questions

What does behavioral finance tell us?

Behavioral finance helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitations of the mind in processing and responding to information.

How does behavioral finance differ from mainstream financial theory?

Mainstream theory, on the other hand, makes the assumptions in its models that people are rational actors, that they are free from emotion or the effects of culture and social relations, and that people are self-interested utility maximizers. It also assumes, by extension, that markets are efficient and firms are rational profit-maximizing organizations. Behavioral finance counters each of these assumptions.

How does knowing about behavioral finance help?

By understanding how and when people deviate from rational expectations, behavioral finance provides a blueprint to help us make better, more rational decisions when it comes to financial matters.

The Bottom Line

The behavioralists have yet to come up with a coherent model that actually predicts the future rather than merely explain, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.

Behavioral finance offers no investment miracles to capitalize on this divergence, but perhaps it can help investors train themselves on how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.