Intro to Behavioral Finance

I predict that in the not-too-distant future, the term “behavioral finance” will be correctly viewed as a redundant phrase. What other kind of finance is there?

Richard Thaler, Founding Father of Behavioral Finance

Investors often make irrational choices when managing their portfolio investments. Such choices are fueled by an array of fears that the human mind is vulnerable to. Psychology looks to break down those fears from a more scientific perspective. The emerging field of behavioral finance seeks to understand what the underlying psychology is behind investment behavior. Human behavior is complex and can seem inconsistent amongst many people, and there are many influences and biases that allow us to understand certain financial and economic choices and how they affect the market.

The Basics

Behavioral finance is the study of psychological influences and biases as they affect the decisions investors make. It’s very closely related to the field of behavioral economics, with the same focus on how psychology, bias, and emotions drive decision making. Within this field, it is assumed that participants in the market are not perfectly rational, but have irrational tendencies like herd behaviors and emotional swings. Investors are overtaken by an array of biases that lead them to make mistakes in the most crucial moments. Historically, finance has failed to account for these biases, leading many to assume that the market was always rational and efficient. In fact, it is seeming more and more likely that the exact opposite is true and that the market is always prone to emotion and bias. 

Traditional Finance Versus Behavioral Finance

Traditional finance seeks to explain that investors think and act rationally without emotions getting in the way. Investors receive knowledge, data, and information that are true and apply them to make a rational decision. Traditional finance assumes that people have complete confidence in themselves and control to make financial decisions in their best interests. Basically, traditional financial principles paint a canvas where everything is smooth and the markets work perfectly in favor of the investor. However, that is not the case as behavioral finance assumes investors, no matter how educated, are still human beings with emotions. In other words, it assumes irrationality, biases, and emotions dominate rationality in an investor. 

Early Days of Behavioral Finance

The history of behavioral finance coincides with the history of behavioral economics. In the early-to-mid 1970s, the prevailing thinking in finance was that the investors are rational and will price any and all available factors and information into prices. This premise is known as the efficient market hypothesis. However, the thinking behind behavioral finance goes back to the days of Adam Smith when he wrote books like Wealth of Nations and the Theory of Moral Sentiments, both of which analyzed the impact that people’s sentiments had on their decisions. Additionally, ideas like bounded rationality began to reveal how limited our rationality and thinking is, which leads to irrational decisions. 

Contributions of Kahneman, Tversky, and Thaler

Jumping forward in time to the late 1970s and early 1980s, several economists and psychologists began to question traditional assumptions in finance. Three academics, in particular, were leading this shift — Daniel Kahneman, Amos Tversky, and Richard Thaler. Today, they are known as the “founding fathers of behavioral finance”. Kahneman and Tversky, who weren’t actually economists, wrote three groundbreaking papers from the mid-70s to the early 80s. They were Judgement under Uncertainty: Heuristics and Biases (1974), Prospect Theory: A Study of Decision Making Under Risk (1979), and The Framing of Decisions and the Psychology of Choice (1981). These laid the foundation for understanding biases and their effects on decision making. 

Thaler, a more traditional finance academic who many may know for his appearance in the movie The Big Short alongside Selena Gomez, was working with Kahneman and Tversky in the late 70s and took their ideas and applied them to a finance context. He wrote a paper titled Toward a Positive Theory of Consumer Choice (1980) that introduced the idea of mental accounting (more on that below), which he later wrote more about in another Mental Accounting and Consumer Choice (1985). 

Throughout the 80s and 90s, the work and ideas that Kahneman, Tversky, and Thaler did formed the basis upon which people understood irrational decision making. Kahneman and Thaler ended up winning the Nobel Prize in Economics — Kahneman won it in 2002 and Thaler won it in 2017. Unfortunately, Tversky died of cancer in 1996, but not after having revolutionized the way people approach finance alongside Kahneman and Thaler. 

Several other famous economists and psychologists also played a role in developing the field of behavioral finance, such as George Akerlof, though Kahneman, Tversky, and Thaler made the foundational contributions to the field.

Key Concepts

There are some key concepts that form the basis for how behavioral finance analyzes investors’ behaviors. 

• Mental accounting: People place different values on money depending on subjective criteria including origin, size, and type. People treat certain assets as less replaceable than others. An example of this is saving up for a new home rather than paying down credit card debt.
• Herd Behavior: People mimic the actions of the herd. When collective actions carry better info than private knowledge thus reinforcing group actions. An example of this is massive stock sell-offs and confirmation bias.
• Emotional Gap: Emotional strains such as anxiety, fear, or excitement that disrupt logical rationally in investment decisions. An example is rapidly selling off position in a stock after a quick drop in stock price.
• Anchoring: the use of irrelevant information as a reference for evaluating an unknown value of a financial instrument. Investors who have an anchoring bias hold on to historical values of financial instruments when making decisions instead of taking into account current market fundamentals. An example is buying the stock at $70 and knowing its all-time high was at $100 so the investor waits until the stock reaches that price again to sell.
• Self-attribution: tendency to be really self-confident and disregard knowledge from others. Attributing success to personal skills and failures to market behaviors, not one’s own. An example is when an investor thinks they are a genius when they get lucky on a 30% profit on their stock pick.

Biases

Investors naturally get caught up with their investments when things go south. In traditional finance theory, biases don’t exist as investors make perfect decisions, but that’s not real life. When you have a large position on a stock or a large amount of money invested in general, you have more emotional connection to the money and therefore are more likely to have a bias. This affects investment decisions regarding that money.

Loss Aversion and Prospect Theory

The loss aversion bias, also known as prospect theory, states that people feel losses more strongly than equivalent gains. For example, a loss of $100 hurts more than the delight of a gain of $100. A gain of $100 feels like you’ve gained $100, but losing $100 may feel like you’ve lost $150 or even $200. This bias gives rise to risk aversion, as investors choose to prioritize avoiding losses as opposed to maximizing gains. To avoid risk, they usually sell appreciated positions too quickly to protect gains. They also end up holding losing positions longer in hopes that future gains can offset those existing losses, as they feel those losses more strongly. 

Kahneman and Tversky found that when presenting two options — getting $1000 with 100% certainty or getting $2500 with a 50% certainty — most people opted for certainty over a higher reward. Unsurprisingly, people were content with settling for less, knowing that they secured a financial gain. However, Kahneman and Tversky flipped the situation of the two choices by turning the gains into losses. Presented with a certain loss of $1000 versus a 50% chance of either no loss or a $2500 loss, the majority of subjects preferred the second option, running the risk that they might lose substantially more, but hoping that they might walk away having lost nothing.

Confirmation Bias

Another bias is the confirmation bias, where the investor has a bias toward accepting information that supports their beliefs even though the information may be flawed. If an investor has a sizable position in a certain stock, then that investor will likely be searching for information that supports his decision to own the stock even when the stock may show signs of declining.

Endowment Effect

The endowment effect occurs when an investor values their asset more when they own it and acts differently depending on the origin of the assets. For example, an unwillingness to invest inheritance money due to an emotional familial connection is an example of this bias. Investment firms like venture capital funds and hedge funds tend to take more risks with the money they have to invest as that money isn’t theirs but rather money from the limited partners who invest in those funds. Compared with how individual investors save their money in less risky investments, like savings accounts and such, it’s easy to see this bias in action.

Experiential Bias

Lastly, another important bias is the experiential bias where the investors’ memory of recent events makes them more likely to believe the event would happen again in the future. For example, many investors exited the stock market after the 2008-2009 market collapse in fear that another such harrowing crisis would occur.

Conclusion

The investor’s chief problem — and even his worst enemy — is likely to be himself.

Benjamin Graham, the father of value investing

Behavioral finance asserts that investors are human, just like the rest of us. They have emotions and biases that cloud their rationality. In the world of finance, investors treat their money more emotionally than rationally and get entangled in a complex web of bias and psychology. Behavioral finance seeks to understand the psychological basis for people’s behaviors and apply them to the sphere of money. Behavioral finance ultimately draws ideas from psychology and finance to generate better insights for how investors can beat their biases and overcome emotions.