Classical economic theory suggests that investors and financial markets move solely on the basis of fundamentals and economic analyses of businesses. However, this efficient market hypothesis doesn’t account for many decisions made by both investors and businesses.

The study of psychological influences on investors and, by extension, markets is called behavioral finance.

What is Behavioral Finance? 

Behavioral finance is a subfield of behavioral economics that proposes that psychological influences and biases affect the financial behavior of investors and financial professionals. 

Moreover, influences and behavioral biases can be the source for the explanation of all types of market anomalies and specifically stock market anomalies such as severe rises or falls in stock prices. 

The Origins of Behavioral Finance

Behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest and make decisions based on personal biases as opposed to facts.

It uses experiments and research to demonstrate that individuals and financial markets are not always rational, and the decisions they make are often flawed.

The study of behavioral economics began as a response to the traditional finance theories that individuals are perfectly rational and always self-interested when it comes to financial decision-making.

Adam Smith originated this concept with rational choice theory, positing that individuals will always make rational decisions based on what maximizes their individual satisfaction. In this theory, the rational person has self-control and is unswayed by emotions or external factors.

Many economists took issue with this understanding of investor behavior, noting that individuals are emotional, have biases and often make decisions that are not in their best interest.

Economists Gary Becker, Herbert Simon, Daniel Kahneman, Amos Tversky, Robert J. Shiller and Richard Thaler all have notable work in the field of behavioral economics and finance, identifying biases in investment decisions.

Behavioral finance is gaining popularity in financial advisor business models and client engagement practices. It is also becoming increasingly important for financial analysts, asset managers and personal finance processes.

The applications of behavioral science to finance are now broad and well-researched. They encompass activities such as spending, trading, financial planning, portfolio management and business commerce.

Additionally, behavioral implications flipping the script on some of the former Nobel prize-winning theories around how economies and financial markets function.

Key Behavioral Finance Concepts

• Mental Accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes. 
• Herd Behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. 
• Emotional Gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear or excitement. Often, emotions are a key reason people do not make rational choices. 
• Self-Attribution: Self-attribution refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. 
• Heuristics: Heuristics essentially means that humans use mental shortcuts when making decisions instead of using more complex and rational reasoning. For example, it is easier to continue acting in the same way you have been, even if a better decision exists.
• Loss Aversion: Loss aversion is the phenomenon that people are more interested in avoiding losses than they are in gaining something. For example, an investor may sell a stock that decreased 20% in value, rather than buying more at the lower price, even if that would lower the average cost of purchase. 

Behavioral Finance in the Stock Market

The efficient market hypothesis (EMH) states that stock prices in a highly liquid market should accurately reflect all available information. 

However, research has shown that long-term patterns in securities markets contradict the EMH and cannot be explained by assuming perfect rationality among investors. This is where behavioral finance theories come into play. 

Behavioral economists argue that markets are not always efficient and that psychological and social factors can influence buying and selling of stocks.

By studying these biases, investors and portfolio managers can attempt to better understand stock market movements and anomalies, such as bubbles and recessions. This knowledge can be applied to analyze market prices and fluctuations for speculation and decision-making.

Market Psychology

The actions of millions of individuals and organizations in economic markets can be influenced by human biases and heuristics, leading to market inefficiencies and underperformance. Understanding the sources of these anomalies in securities valuations can improve market outcomes.

Trading Psychology

Trading psychology refers to the emotions and mindset that influence a trader’s decision-making and ultimately affect the outcome of their trades.

Negative mental states and biases explained below can lead to poor investment outcomes.

Behavioral Finance Biases That Can Impact Investing Decisions

Confirmation Bias

Confirmation bias is a cognitive bias that leads investors to favor information that confirms their existing beliefs about an investment. They tend to accept information that supports their decision, even if it is flawed, instead of critically evaluating it, to confirm that they are right about the investment.

This can manifest in various ways. For example, a consumer may only seek out reviews that support their preferred brand, while an investor may overweight their portfolio with the stock of the company they work for, due to a belief in its success.

Often, confirmation bias can lead to overexposure to risk in the portfolio. Even those who try to be objective and consider the fundamentals of an investment may give more weight to the pros if they have a preconception in favor of it. Confirmation bias is a subtle bias that can be difficult to recognize and overcome.

Hindsight Bias

Hindsight bias is a cognitive bias that causes individuals to overestimate the accuracy of their predictions after an event has occurred.

For example, an investor may believe they knew a stock’s price would decline and attribute their success to their own analysis, rather than recognizing that it could have been a coincidence.

This bias can impact the financial analysis process by leading individuals to attribute causes to events that may not be accurate or relevant.

Anchoring Bias

Anchoring bias refers to basing judgment of value on available numbers. This can lead to overestimating the cost of things, such as when wealthy individuals are accustomed to high prices.

Think of Lucille Bluth’s iconic quote in Arrested Development: “I mean, it’s one banana, Michael. What could it cost, ten dollars?”

For someone who spends more on average, their understanding of the value of a dollar is different than someone living on a strict budget.

Basing investment decisions on anchors can be dangerous and cause investors to make rash financial decisions. Mostly, these investors will make decisions based on their own opinion of value and not on the intrinsic value of a product. 

Familiarity Bias

Familiarity bias refers to the tendency of individuals to prefer investments that are familiar to them. This bias can manifest in a number of ways, such as investing in companies or industries that are geographically close to the investor, or investing in companies that the investor has personal experience with, or has heard of through the media.

Investors who fall victim to familiarity bias can see a lack of diversification in their investment portfolios, as investors may neglect to consider other investment opportunities that they are not familiar with.

Additionally, this bias can lead investors to overvalue companies that they’re familiar with, and overlook potential risks associated with these investments.

Familiarity bias can also make investors less likely to sell an investment even if it’s not performing well, based on the emotional attachment to the familiar investment.

Experiential Bias

Experiential bias, also known as recency or availability bias, is a cognitive bias that occurs when individuals allow recent events to shape their actions and perceptions. This bias can cause individuals to overestimate the likelihood of an event occurring.

For example, if an investor takes a risk and invests in an online marketplace startup, and it doesn’t perform well, they may be less likely to invest in a similar business in the future.

This is an example of experiential bias, because the failure of one startup may not be indicative of the potential success of others, and it’s not accurate to generalize all other similar businesses based on the failure of one startup.

Understanding Heuristics

Humans make thousands of decisions every day. What should I eat for lunch? What should I wear? What show should I watch on Netflix? We typically make these choices with almost no thought — psychologists refer to this as “heuristics.”

These mental shortcuts are helpful to ensure we’re not paralyzed by unimportant daily decisions, but they can lead to some mistakes.

For example, investors are naturally biased towards selling investments that are doing well for us, but holding on to those that are doing poorly. Many investors also fail to enroll in employer corporate retirement plans, even when the employer offers a significant contribution match.

An example of a common heuristic in investing is the belief that past performance of an investment is indicative of future returns. This can lead to overlooking important factors, such as changes in the economy or overvaluation of a stock.

For instance, an investor may assume that a mutual fund with positive returns over the past five years will continue to perform well, without considering changes in management or other external factors that may affect the fund’s performance.

Another example is the belief that a “sale price” is a good deal without considering the accuracy of the reference point (i.e. the normal price). This can result in making a purchase decision based on inaccurate information, leading to negative financial consequences.

However, people can become aware of these errors and adjust their decision-making processes. 

Overcoming Financial Behavior Biases

There are several ways to try to overcome financial behavior biases, some of which include:

1. Creating a financial plan: A financial plan is a comprehensive document that outlines an individual’s current financial situation and future financial goals. It also includes a detailed strategy for achieving those goals. Having a financial plan can help overcome financial behavior biases by providing a clear and structured approach for making financial decisions.
2. Avoiding emotional decision-making: When emotions run high, biases are more likely to occur. Avoiding emotional decision-making can help individuals overcome biases and make sound decisions.
3. Understanding volatility: Understanding the volatility of different investments can help individuals make more informed decisions and avoid being swayed by biases like overconfidence. By being aware of the volatility of an investment, individuals can better prepare for market fluctuations and make more sound investment decisions.
4. Working with a financial advisor: A financial advisor can help individuals overcome financial behavior biases by providing objective advice and helping individuals create a well-diversified investment portfolio.

It’s important to remember that biases are a natural part of human nature, and it’s not possible to eliminate them completely, but by being aware of them and taking steps to overcome them, individuals can make more sound financial decisions.

The Bottom Line

Behavioral economics is a field that examines the ways in which psychology and emotions influence economic decision-making. It helps us understand why people make certain financial decisions and how these decisions can impact the economy as a whole.

Behavioral finance tells professionals about the causes of someone’s financial decisions and the impact emotions can have on the economy. By understanding these biases, individuals can make better financial decisions and avoid costly mistakes.

However, it’s important to remember that biases are a natural part of human nature, and it’s not possible to eliminate them completely. But by being aware of these biases, and taking steps to overcome them, individuals can make more sound financial decisions.

With the help of a financial plan, research and even a financial advisor, individuals can take control of their finances and achieve their financial goals.

The information in this article is for educational purposes only. This information should not be construed as investment advice or form the basis of an investment decision.