What Is Behavioral Finance?

Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to explain stock market anomalies, such as severe rises or falls in stock price. The purpose is to identify and understand why people make certain financial choices. Within behavioral finance, it is assumed the information structure, and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.

1:38

Behavioral Finance

Understanding Behavioral Finance

The efficient market hypothesis (EMH) proposes that at any given time in a liquid market, or where there are plentiful buyers and sellers, prices reflect all available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Many traditional models are based on the belief that market participants always act in a rational and wealth-maximizing manner. This belief in consistent, rational behavior can severely limit a financial model's ability to make accurate or detailed predictions.

Behavioral finance attempts to fill this void by combining scientific insights into cognitive reasoning with conventional economic and financial theory. More specifically, behavioral finance studies different psychological biases that humans possess. These biases, or mental shortcuts, while having their place and purpose in nature, lead to irrational investment decisions. This understanding, at a collective level, gives a clearer explanation of why bubbles (extreme buying) and panics (extreme selling) occur. Also, investors and portfolio managers have a vested interest in understanding behavioral finance, not only to capitalize on stock and bond market fluctuations but to also be more aware of their own decision-making process.

Key Takeaways

  • Behavioral finance proposes psychology-based theories to explain stock market anomalies, such as severe rises or falls in stock price.
  • Behavioral finance attempts to identify and understand why people make certain financial choices by studying their biases.
  • The self-attribution bias is the habit of attributing favorable outcomes to expertise and unfavorable outcomes to bad luck.
  • The herd instinct leads people to follow popular trends without any deep thought of their own.

Behavioral Finance Concepts

Behavioral finance encompasses four main concepts: mental accounting, herd behavior, anchoring, and high self-rating. Mental accounting refers to the propensity for people to allocate money for specific purposes. Herd behavior states that people tend to mimic the financial behaviors of the majority or the herd. Anchoring refers to attaching a spending level to a certain reference, such as spending more money on what is perceived to be a better item of clothing. Lastly, high self-rating refers to the tendency of investors to rank themselves better than others or higher than an average person. For example, investors might believe that they're an investment guru when the investment performs well while dismissing their contributions to the investment when it performs poorly.

Biases Studied in Behavioral Finance

Of the four concepts, two (herd instinct and self-rating or self-attribution) are biases that significantly affect financial decisions. A prominent psychological bias is the herd instinct, which leads people to follow popular trends without any deep thought of their own. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. The herd instinct is correlated closely with the empathy gap, which is an inability to make rational decisions under emotional strains, such as anxiety, anger, or excitement.

The self-attribution bias, a habit of attributing favorable outcomes to expertise and unfavorable outcomes to bad luck or an exogenous event, is also closely studied within behavioral finance. George Soros, a highly successful investor, is known to account for this tendency by keeping a journal log of his reasoning behind every investment decision. 

Many other biases and tendencies are studied within behavioral finance, including:

Disposition Bias

Disposition bias refers to when investors sell their winners and hang onto their losers. Investors' thinking is that they want to realize gains quickly. However, when an investment is losing money, they'll hold onto it because they want to get back to even or their initial price. Investors tend to admit their correct about an investment quickly (when there's a gain). However, investors are reluctant to admit when they made an investment mistake (when there's a loss). The flaw in disposition bias is that the performance of the investment is not tied to the entry price for the investor. In other words, if the fundamentals have worsened for the investment, it'll likely decline in price regardless of the investor's entry price.

Confirmation Bias

Confirmation bias is when investors have a bias to accepting information that confirms their already-held belief in an investment. If information surfaces, investors accept it readily to confirm that they're correct about their investment decision—even if the information is flawed.

Availability Bias

An availability bias occurs when investors' memory of recent events makes them biased or believe that the event is far more likely to occur again. For example, the financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the coming years. The experience of having gone through such a negative event increased their bias or likelihood that the event could reoccur. In reality, the economy recovered, and the market bounced back in the years to follow.

Loss Aversion

Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, they're far more likely to try to assign a higher priority on avoiding losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn't likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational standpoint.

Familiarity Bias

The familiarity bias is when investors tend to invest in what they know, such as domestic companies or locally-owned investments. As a result, investors are not diversified across multiple sectors and types of investments, which reduces risk. Investors tend to go with investments that they have a history with or have familiarity.