INVESTMENT AND PORTFOLIO MANAGEMENT CHAPTER 6
BEHAVIORAL FINANCE
TOPICS:
1. What Is Behavioral Finance?
2. Traditional Finance Theory
3. Behavioral Finance Theory
4. Decision Making Errors and Biases
5. Top Biases in Behavioral Finance
6. Overcoming Behavioral Finance Issues
How processing errors and biases impact investors:
● What is Behavioral Finance?
Behavioral finance is the study of the influence of psychology on the behavior of investors or financial
analysts. It also includes the subsequent effects on the markets. It focuses on the fact that investors are
not always rational, have limits to their self-control, and are influenced by their own biases.
● Traditional Financial Theory
In order to better understand behavioral finance, let’s first look at traditional financial theory.
Traditional finance includes the following beliefs:
Both the market and investors are perfectly rational
Investors truly care about utilitarian characteristics
Investors have perfect self-control
They are not confused by cognitive errors or information processing errors
● Behavioral Finance Theory
Now let’s compare traditional financial theory with behavioral finance.
Traits of behavioral finance are:
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INVESTMENT AND PORTFOLIO MANAGEMENT CHAPTER 6
Investors are treated as “normal” not “rational”
They actually have limits to their self-control
Investors are influenced by their own biases
Investors make cognitive errors that can lead to wrong decisions
Behavioral finance explores how factors like psychological influences and biases distort the logical reasoning of
people. An environment with well-informed investors following rational decisions is always an important
constituent for sustainable financial market practices, but different concepts like bounded rationality restrict it
from happening.
Traders rely greatly on technical indicators. However, in many cases, it has been noted that investors' behavior in
markets is often strange since it may be the opposite of what the technical market indicators may point to. The
goals of any investor are to make profits from a market, and the decisions they make to achieve this may not
always be rational.
The two main constituents, cognitive psychology and the limits to arbitrage, can interpret diverse market scenarios
where the influence of human psychology in financial decisions occurs. Therefore, understanding cognitive bias
like overconfidence, herd mentality, and loss aversion is beneficial. Furthermore, the forces of arbitrage may fail,
and this limit to the arbitrage process contributes to the persistence of financial market anomalies. Altogether the
study explains the investor's irrational decisions and discloses market behavior. However, the problem is that the
behaviors of investors combined with their different biases make them difficult to predict.
● Decision-Making Errors and Biases
Let’s explore some of the buckets or building blocks that make up behavioral finance.
Behavioral finance views investors as “normal” but being subject to decision-making biases and errors. We can
break down the decision-making biases and errors into at least four buckets.
1) Self-Deception
The concept of self-deception is a limit to the way we learn. When we mistakenly think we know
more than we actually do, we tend to miss information that we need to make an informed
decision.
2) Heuristic Simplification
We can also scope out a bucket that is often called heuristic simplification. Heuristic
simplification refers to information-processing errors.
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3) Emotion
Another behavioral finance bucket is related to emotion, but we’re not going to dwell on this
bucket in this introductory session. Basically, emotion in behavioral finance refers to our making
decisions based on our current emotional state. Our current mood may take our decision-
making off track from rational thinking.
4) Social Influence
What we mean by the social bucket is how our decision-making is influenced by others.
● Top Biases in Behavioral Finance
Behavioral finance seeks an understanding of the impact of personal biases on investors. Here is a list of
common financial biases.
Common biases include:
a) Confirmation bias: The confirmation bias occurs when the investors align to the information
that matches with their beliefs. The data could be wrong, but as long as it fits with their views,
they end up relying on it.
b) Experiential bias: It occurs when an investor's memories or experiences from past events make
them choose sides even when such a decision is not rational. For instance, previous or current
bad experience leads them to avoid similar positions.
c) Loss aversion: Loss aversion makes investors avoid taking a risk even if it earns high returns.
They give priority to restraining from experiencing losses rather than experiencing high returns.
d) Overconfidence: Overconfidence reflects when investors overestimate their abilities or trading
skills and make decisions forgoing factual evidences.
e) Disposition bias: It explains the propensity of investors to hold on to the stocks even if the
prices are declining, believing that the prices will appreciate in the future and, at the same time,
sell the well-performing stocks. Such investors tend to hold on to a stock losing money, hoping
that the price will soon increase. In their minds, it's only a matter of time before the tides
change for them, and they can then make profits on all their positions in a market.
f) Familiarity bias: The familiarity bias is reflected when investors place their investment in the
stocks from the industry they know and understand rather than going after securities from an
unrelated field. In this process, they may lose new or innovative opportunities that are
revolutionary.
g) Mental accounting: People's budgeting process or spending habits may vary based on
circumstances. That is, they don't maintain a consistent pace. For instance, people may spend
for luxury in a mall or while on vacation, and they also possess a modest lifestyle at home or
when they are back from vacation.
● Overcoming Behavioral Finance Issues
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There are ways to overcome negative behavioral tendencies in relation to investing. Here are some
strategies you can use to guard against biases.
Focus on the Process
There are two approaches to decision-making:
Reflexive – Going with your gut, which is effortless, automatic and, in fact, is our
default option
Reflective – Logical and methodical, but requires effort to engage in actively\
Relying on reflexive decision-making makes us more prone to deceptive biases and emotional
and social influences.
Establishing logical decision-making processes can help protect you from such errors.
Get yourself focused on the process rather than the outcome. If you’re advising others, try to
encourage the people you’re advising to think about the process rather than just the possible
outcomes. Focusing on the process will lead to better decisions because the process helps you
engage in reflective decision-making.
Prepare, Plan and Pre-Commit
Behavioral finance teaches us to invest by preparing, by planning, and by making sure we pre-
commit. Let’s finish with a quote from Warren Buffett.
“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have
ordinary intelligence, then what you need is the temperament to control urges that get others
into trouble.”