An Overview of Behavioral finance
Psychologists and sociologists have fought mainstream finance and economics theories for decades, claiming that humans are not rational utility-maximizing actors and that markets are inefficient in the real world. The field of behavioral economics arose in the late 1970s to address these issues, amassing a large body of evidence of people acting “irrationally” on a regular basis. Behavioral finance is the name given to the application of behavioral economics to the world of finance.
It’s not difficult to imagine the stock market as a person from this perspective: It has mood swings (and price swings) that range from irritable to euphoric in an instant; it can overreact hastily one day and make amends the next. Can human behavior, on the other hand, really aid our understanding of financial matters? Is it possible to develop practical strategies by analyzing the market’s mood? It’s possible, according to behavioral finance theorists.
Important Points to Remember
- People often make financial decisions based on emotions and cognitive biases, rather than being rational and calculated, according to behavioral finance.
- Investors, for example, frequently hold losing positions rather than suffer the pain of a loss.
- Investors buy in bull markets and sell in bear markets because of their instinct to follow the herd.
- In the past, behavioral finance has been useful in analyzing market returns, but it has yet to produce any insights that can help investors develop a strategy that will outperform in the future.
Some Behavioral finance findings
Behavioral finance is a branch of behavioral economics that contends that people are not nearly as rational as traditional finance theory predicts when making financial decisions like investing. Behavioral finance provides some interesting descriptions and explanations for investors who are curious about how emotions and biases drive stock prices.
The notion that stock market movements are driven by psychology defies established theories that advocate for efficient financial markets. For example, proponents of the efficient market hypothesis (EMH) argue that the market quickly prices any new information relevant to a company’s value. As a result, future price movements are unpredictable because all available (public and some non-public) data has already been discounted in current prices.
The efficient market theory, on the other hand, is difficult to swallow for anyone who has lived through the Internet bubble and subsequent crash. Irrational behavior, according to behaviorists, is more common than anomalies. In fact, using very simple experiments, researchers have regularly reproduced examples of irrational behavior outside of finance.
“It’s an understatement to say that financial well-being influences mental and physical well-being, and vice versa. It’s just a cyclical thing that occurs “Life Planning Partners Inc.’s founder and director of financial planning, Dr. Carolyn McClanahan, stated. “When people are stressed about money, chemicals called catecholamines are released. People have probably heard of epinephrine and other similar substances that set your entire body on fire. As a result, it has an impact on your mental health and your ability to think. It has an impact on your physical health, wears you out, makes you tired, and prevents you from sleeping. Then, because you can’t sleep, you start acting out in order to cope.”
The Importance of Losses vs. the Importance of Gains
Here is an example of an experiment: Offer someone the option of a guaranteed $50 or the chance to win $100 or nothing by flipping a coin. It’s likely that the person will take the safe bet. Offer a choice of 1) a guaranteed loss of $50 or 2) a loss of $100 or nothing based on a coin flip. Rather than accepting a $50 loss, the person will most likely choose the second option and flip the coin. Loss aversion is the term for this.
Even though the odds of the coin landing on one side or the other are the same in any scenario, people will choose the coin toss to avoid a $50 loss rather than the coin flip, which could result in a $100 loss. This is due to the fact that people prioritize the possibility of recouping a loss over the possibility of greater gain.
The priority of avoiding losses applies to investors as well. Consider Nortel Networks shareholders, whose stock dropped from over $100 per share in early 2000 to less than $2 just a few years later. Investors often hold stocks rather than suffer the pain of a loss, regardless of how low the price drops. They believe that the price will eventually rise.
The Self vs. the Herd
People’s proclivity to imitate others is explained by the herd instinct. When a market is rising or falling, investors are afraid that others know more or have more information than they do. As a result, investors are compelled to follow in the footsteps of others.
Investors tend to place too much weight on judgments based on small samples of data or single sources, according to behavioral finance research. An analyst who picks a winning stock, for example, is known to be credited with skill rather than luck by investors.
Beliefs, on the other hand, are difficult to shake. During the late 1990s, for example, one popular belief among investors was that any sudden drop in the market was a buying opportunity. This buy-the-dip mentality still exists. Investors are frequently overconfident in their assessments, preferring to focus on a single “telling” detail over the more obvious average. As a result, they miss the big picture by focusing too much on the small stuff.
Is Behavioral Finance Actually Useful?
We can consider whether these studies will assist investors in outperforming the market. After all, rational flaws should provide a plethora of lucrative opportunities for astute investors. In practice, however, few, if any, value investors use behavioral principles to determine which cheap stocks offer consistently above-average returns.
Behavioral finance research has a bigger impact in academia than in real-world money management. While theories point to a variety of rational flaws, the field offers little in the way of solutions for profiting from market manias.
Robert Shiller, author of “Irrational Exuberance” (2000), demonstrated that the stock market was in the midst of a bubble in the late 1990s. He couldn’t predict when the bubble would burst, though. Similarly, today’s behaviorists are unable to predict when the market will top or bottom, just as they were unable to predict when the market would bottom following the 2007-2008 financial crisis. They can, however, describe the appearance of a significant turning point.
Most Commonly Asked Questions
What can we learn from behavioral finance?
Human emotion, biases, and cognitive limitations of the mind in processing and responding to information all play a role in financial decisions such as investments, payments, risk, and personal debt, according to behavioral finance.
What distinguishes behavioral finance from conventional financial theory?
Mainstream theory, on the other hand, bases its models on the assumptions that people are rational actors, free of emotion and the effects of culture and social relations, and self-interested utility maximizers. It also assumes that markets are efficient and that businesses are rational profit-maximizing entities. Each of these assumptions is debunked by behavioral finance.
What good does it do you to know about behavioral finance?
Behavioral finance provides a blueprint to help us make better, more rational financial decisions by understanding how and when people deviate from rational expectations.
Behavioral economists have yet to develop a coherent model that actually predicts the future rather than merely explaining what the market did in the past with the benefit of hindsight. The main takeaway is that theory does not provide guidance on how to beat the market. Instead, it tells us that market prices and fundamental values diverge for a long time due to psychology.
Behavioral finance does not promise investment miracles to capitalize on this divergence, but it may be able to help investors train themselves to be more aware of their actions and, as a result, avoid costly mistakes.