Behavioral Finance Explained

Behavioral finance can be defined as the intersection of psychology, behavior, and finance. Maybe you’ve been in the grocery store and thought $2.00 was too much for an apple, but were happy to pay $1.99 for a pear.

Behavioral finance looks to understand why people have certain psychological biases which they may not be aware of and endeavors to answer the following question: How does our unconscious biases and psychology affect market prices and investor habits?

Behavioral economics and behavioral finance in particular is interested in understanding psychological mechanisms behind investment decisions and financial markets.

What Is Behavioral Finance? 

Behavioral finance is the field of study which looks to understand why people make irrational financial decisions. It was initially discovered by a group of scientists including Nobel prize winner Daniel Kahneman. Their idea was that people are irrational, and those who are irrational can be influenced in their decision-making; especially if their psychology could be understood. 

Behavioral Finance Definition

The Websters Dictionary defines behavioral finance as: Relating to or concerned with the social, psychological, and emotional factors that affect financial decisions and behavior…

Pillars of Behavioral Finance 

There are two primary pillars of behavior in finance to understand. The pillars play into one another and are not exclusive; one influences the other:

• Psychology: looks to understand the rationale or thoughts that go into making financial decisions at the individual level
• Finance: based on these thoughts what are the financial transactions or actions taken by the individual based on their psychology

Understanding Economic Behavior and Economic Psychology 

Economic behavior and economic psychology are the studies of how individuals and groups make decisions about the allocation of resources. This field focuses on understanding why people behave the way they do in economic situations.

Understanding behavioral finance can give you an advantage in understanding markets and financial transactions, which will allow you to create opportunities

What Does Behavioral Finance Tell Us? 

Behavioral Finance tells us at a macro level what types of financial decisions, whether investing, spending, or financing, we can expect to be taken by individuals based on their thinking and emotions.

The 5 Main Concepts of Behavioral Finance: 

There are five concepts to behavioral finance to understand

1. Mental Accounting 

Mental accounting is described as the psychology of humans to create different accounts in their minds for different types of money. For example a car payment may be $400 a month, but that money is dedicated for a car payment whereas an impulse slice of pizza for $3.00 may cause pause in some.

2. Herd behavior 

Herd behavior is the tendency of individuals to act impulsively with the majority. An example of this may be at a concert where the crowd begins to start jumping up and down. Herd behavior would explain why an individual may begin jumping as a result.

3. Anchoring 

Anchoring is the psychological fixation on a price within one's mindset. This means that if an individual thinks that something should cost $40.00, any price above $40.00 would be expensive, and under $40.00 would be a discount. Anchoring often happens in stock purchasing, where the purchase price of a stock acts as the anchor. 

4. Self-deception 

Self-deception is when people lie to themselves about their beliefs, preferences, or abilities. This can affect their decisions and behavior, and can lead to biases and errors in judgment. A common example is imposter syndrome, where an individual may not feel fit enough to complete a job they are actually qualified for.

5. Emotion 

Emotion plays a significant role in behavior economics in that it impacts how information is evaluated and calculated within one's mind. This may look like a person who knows a friend whose used car was nothing but issues, so may have unconscious bias towards used cars. 

Understanding the biases that feed into behavioral finance and evaluating them against financial decisions can create clarity for investors

The 10 Main Biases in Behavioral Finance

 There are ten biases to understand when considering and applying behavioral finance. These biases are common among individuals and often are referred to in the study of behavioral finance.  

Understanding Behavioral Finance Biases 

Bias is often described as a tendency to favor or believe something in a particular way, whether with or without good reason. These are the common biases that are often associated with behavioral finance.

1. Overconfidence & illusion of control 

This is the individual's tendency to feel overconfident in their own knowledge, or likelihood of success

2. Confirmation bias 

The tendency to only make decisions which agree with your beliefs you prior to the decision being made

3. Experiential bias 

An individual's inclination to only make decisions which are in line closer to experiences which they’ve already had

4. Loss Aversion 

The tendency for individuals to make decisions which minimize risk or the losses they should experience from a decision

5. Self-Attribution bias 

Where people attribute their successes to their own abilities and efforts, but attribute their failures to external factors

6. Framing bias

 The bias that is demonstrated by how information is presented to individuals which influence decisions. A price slashed through with a new lower price presented may be an example. 

7. Representative bias

Individuals make judgments based on how closely something resembles a typical example or stereotype of the decisions outcome

8. Familiarity bias 

People's tendency to lean towards and make decisions which they are more familiar with, whether personal experience or learnings.

9. Anchoring bias

 People's bias to make decisions based on a predetermined attribute of the decision, such as a price or a place. Any movement away from the individuals anchor could influence decisions

10. Disposition bias 

People's decisions and judgments are influenced by their own emotional states. This can involve people making different decisions depending on whether they are feeling happy verses sad

While behavioral finance is one school of economic thought among many, in recent years it has proven to be one of the most lucrative

Costs of Irrational Financial Behavior

Everyday people make irrational financial decisions based on this study of financial behavior. The consequences can be material in many ways

Implications for Individuals 

The tendency to give into your biases may lead individuals to avoid risk or stick with what they know, leading to the opportunity cost of what could have been had they made rational decisions

Implications for Traders and Investors 

Traders and investors often trade with familiar industries and exercise other biases such as anchoring to a purchase price of a stock which may lead to financial losses on opportunities. 

Implications for Financial Institutions 

Financial institutions may exercise these biases and exercise financial behaviors which forego providing crucial financing to individuals who may have had the next best investment for the institution. 

How to Overcome Financial Behavioral Biases 

The first step is understanding what biases exist in financial behavior. From there an individual might look to determine whether their decision has been impacted by any biases and weigh the pros and cons and determine if they’ve been impacted by your biases. This process of applying logic to your thinking may break you free from financial behavior biases. 

Behavioral Finance Examples in Real Life 

A person who has purchased a car at $30,000.00 may be in a situation where the car continues to require maintenance. Time after time the car goes to the shop and each time the repair bill is $2,000.00 leading the person to $16,000.00 in car bills. Rather than cut their losses and sell the car, the person may believe that their troubles will end soon, one last time, and tend to continue servicing the car.
A person may not want to purchase a new pair of shoes because they believe that shoes should only cost $60.00 and have not found any yet. However, they stumble across a sale where shoes, which used to be $140.00, are now marked to $69.99, pushing them to believe they got a great deal and make a purchase. 

Behavioral Finance in the Stock Market 

The stock market is a fantastic place to witness markets exercise this science of psychology and economics. With only historic data to reference, traders may believe that history should repeat and make transactions based on past events.

Behavioral Investing

 An online forum is saying that a certain stock is destined to make large gains in the short term. People continue to comment that they are going to purchase the stock. Herd behavior pushes you to purchase the stock without any other thought in your mind. 

Behavioral finance is a fundamental pillar of economics in the twenty first century and a must understand for those looking to improve their financial position 

How Does Behavioral Finance Differ From Mainstream Financial Theory?

 Behavior finance describes individuals as irrational whereas mainstream finance assumes people are rational and always make the best financial decisions. The two differ in many ways. 

Efficient Market Hypothesis and its Shortcomings 

Adam Smith first wrote about efficient markets in 1776 in “The Wealth of Nations” which describes capitalism, finance, and principles of economics and their benefits. While it was ahead of its time, its shortcoming assumed that the best decision was always made in a transaction. 

Adaptive Market Hypothesis 

Describes financial markets as being inherently efficient and that investors and prices adapt to new information in a rational and systematic way.

Deposition Theory

Borrowing from the loss aversion bias, this theory describes how individuals tend to sell assets at a gain and hold assets which are trading at a loss, which influences how our markets trade.

How Is Knowing About Behavioral Finance Helpful? 

Knowing about behavioral finance can help individuals make better financial decisions by providing insights into the psychological factors that influence their behavior. It can also be helpful for investors and financial professionals, as it can provide insights into market behavior and help to identify and exploit inefficiencies and mispricings.

Final Word 

• Behavioral finance is a field that studies psychology and economics to study how these factors influence financial decisions and markets.
• It understands that people are influenced by a wide range of factors, and that their behavior is often irrational, and influenced by biases and emotions.
• Behavioral finance can help to explain and predict market movements that are difficult to explain using traditional financial theory, such as bubbles and crashes.
• Knowing about behavioral finance can be helpful for individuals, investors, and financial professionals, as it can provide valuable insights into how people make financial decisions and how markets behave.