Successful business people like to think they're cool under pressure. But is that true? Important decisions such as making a key investment, increasing production or expanding into new lines are all clouded by human emotion. Behavioral finance has emerged as a field of study which tries to explain and mediate these deviations in investor behavior from the expectations formed by traditional finance or the efficient markets predicted by neoclassical economics. While there is still much debate as to the validity of behavioral finance, it is becoming increasingly relevant. Daniel Kahneman and Amost Tversky won the Nobel Prize in economics in 2002 for their work in behavioral economics, specifically dealing with people's emotional irrationality when it comes to avoiding losses. (For more, see: Behavioral Bias - Cognitive Vs. Emotional Bias In Investing.)
Emotional biases are caused by the way individuals' emotions and sentiments alter the frame of the information and the decision, rather than the process used to analyze it. While cognitive errors can be corrected through educating and informing decision-makers, emotional biases are much more difficult to mediate.
Some of the emotional biases that have been identified are:
- Loss aversion is a key feature of prospect theory, where people place a grater “value” on losses than gains of the same size. Because of loss aversion, people end up taking on more risk rather than sell a stock at a loss or halt operations of a losing venture. Instead, they are apt to double down in hopes that the loss will eventually turn into a gain. Overcoming the mental anguish of recognizing paper losses will help in dealing with this emotional bias.
- The House money effect is when people take on more risk when investing profits than principal. Those who are up money will therefore be prone to lose those profits instead of using them wisely. Lottery winners who blow their millions in a short period of time or traders who incur substantial losses following a winning streak are good examples.
- Overconfidence bias is the illusion of having superior information or a superior ability to interpret information. Most people believe their skills and foresight are better than average, which can lead people to underestimate downside risk while overestimating upside potential. Part of overconfidence is self-enhancing behavior where individuals seek to take more credit for successful outcomes than is due, and self-protecting behavior which places the blame on someone or something else in the case of a failure.
- Status-quo bias is an individual's tendency to stay put in their current investments or line of business rather than undergo change, even if change is warranted. This can explain why workers rarely re-balance or re-allocate their retirement account balances or why some companies lose out to more nimble competitors.
- Endowment effect serves to value an asset already held higher than if it were not already held. In other words, things you own are inherently more valuable to you than things you don't yet own. The effect is to hold on too long to losing investments or those gained through gift or inheritance. It also can lead to a market disconnect between the buyer of an object and its seller who irrationally believes it is worth more than it is.
- Regret aversion arises from taking or not taking action for fear that the decision will end up being the wrong one. This can lead to those who've made poor decisions to act defensively and for others to stay in low-risk investments rather than act on a deal which might go sour. This limits upside potential and allows for a herd mentality.
- The Gambler's fallacy is when a reversion to the mean is wrongly predicted. For example, a gambler playing roulette in a casino can wrongly believe that a 'red' number is due merely because a long string of 'black' numbers have recently occurred. This is wrong because each spin of the roulette wheel is an independent trial that has no bearing on past or future outcomes. Investors or business owners may fail to see changes in the fundamentals and wrongly assume things will return to normal. (For more, see: Effects of Behavioral Biases on Investment Decisions.)
The Bottom Line
Behavioral finance describes the ways that investors and decision-makers can act irrationally, due to both cognitive errors and emotional biases. Humans are emotional beings and there is no way to circumvent this human element when it comes to making business decisions. Understanding these errors and biases, however, can help alleviate them in order to make better, more rational decisions when it comes to business and money matters. Behavioral finance is descriptive, it tells us a little about how the real world actually works, but it does not yet aim to prescribe a universal set of steps to achieve the full rationality anticipated by traditional financial theory.