Behavioral Finance: Psychology meets trading

Trading concepts

Behavioural Finance
  • Behavioral finance is a sub-field of behavioral economics.
  • It is built on the assumption humans are not rational individuals.
  • It also propounds that psychological influences and biases can cause market anomalies and stock market anomalies in particular.

The phrase “behavioral finance” bewilders probably everyone at first exposure and rightly so. Everyone feels that “behavior” and “finance” are two completely different things. How is it even possible to interlink these two in the same phrase? Behaviour is a humanistic trait that revolves around emotions, personality, sociology, and psychology. Conversely, finance involves numbers, statistics, equations, income statements, balance sheets, and so on. Both of these concepts are miles apart but mix together in this phrase “behavioral finance.” Why is it? Let’s explore behavior finance definition, behavioral finance theory, its characteristics, and biases.

What is it? Let’s start with a definition!

Behavioral finance is a sub-field of behavioral economics. It proposes that human psychology and finance are interlinked. According to behavioral finance, psychological influences and biases directly affect the financial behaviors of finance professionals including investors and traders. Moreover, it also propounds that psychological influences and biases can cause market anomalies and stock market anomalies in particular. 

Explanation of behavioral finance

Standard finance assumes that human beings are rational and they make logical decisions. That means humans analyze almost every aspect of a situation and then make a decision that seems the best. But here, the behavioral finance advocates raise a serious question and it is a very pertinent one, are humans really rational? Do they make rational decisions each and every time? 

In the past few years, millions of people across the globe started investing and trading. Most of their investment decisions stand on research, logic, and reasoning. But, some of the decisions are really irrational. They might be a result of their mood or instincts. There are chances that there may not be any reasoning behind those trading decisions. Why does it happen? Why so-called rational human beings make such irrational decisions? Behavioral finance offers answers to such questions. It elaborates how psychological influences and biases affect human beings to make irrational financial decisions. The two biggest movers are fear and greed.

Behavioral finance theory

According to the behavioral finance theory, markets are inefficient.

On the other hand, investors, traders, or finance professionals:

  • Are “normal” not “rational” beings
  • Have limited “self-control”
  • Are influenced by their own psychological influences and biases
  • Are prone to make cognitive errors leading to wrong decision making 

Behavioral finance biases

The behavioral finance thesis covers the following main biases.

  1. Anchoring: Anchoring in behavioral finance theory means the use of irrelevant information. For example, when investors make reference to an irrelevant price point.
  2. Overreaction and the availability bias: Overreaction in behavioral finance means investors often overreact to the news feed. Such an overreaction can cause disproportionate effect on the financial markets. Moreover, the availability bias means investors and human beings tend to make decisions based on close and available events. 
  3. Mental accounting: Mental accounting in behavior finance theory means the tendency of human beings to allocate money for particular purposes. 
  4. Herd behavior: Herd behavior means the tendency of human beings to mimic or copy the crowd. Herding in stock markets is particularly damaging as it may cause a dramatic rise or fall.
  5. Confirmation and hindsight: Confirmation and hindsight mean investors tend to filter out things contrary to their views. They simply ignore them no matter how important they might be. Conversely, they pay more attention to things that are in accordance with their preconceived ideas, plans, and opinions. 
  6. Gambler’s fallacy: Gambler’s fallacy in behavioral finance means the tendency of investors to gamble. They gamble in trading and use historical data to predict the future. However, every trading day, hour, minute, and even second is independent. Therefore, past data cannot be a good source to predict future prices.
  7. Overconfidence: When traders make a few successful trades, they become overconfident. They begin to believe that they have supernatural powers to beat the market and gain profits. 
  8. Narrative fallacy: Narrative fallacy is a bias according to this theory. It means that humans have a limited ability to objectively analyze information. Thus, humans let irrelevant information cloud the facts and figures. It limits their ability to make rational decisions. 

Behavioral finance theory vs traditional finance theory

There are several aspects in which behavioral finance is significantly different from traditional finance such as:

  • It considers risk as a subjective term. It believes that risk cannot be measured and everyone has a different risk-taking capacity. Conversely, traditional finance theory takes a risk as an objective term. It proposes that risk can be measured.
  • It considers humans irrational who cannot make rational and logical decisions. Whereas, traditional finance theory states that humans are rational beings who make each decision logically. 
  • It proposes that traders make decisions inconsistently because several factors affect decision-making. As the behavior of the decision-maker changes, decision-making gets affected. On the other hand, traditional finance theory assumes that decisions are made consistently.

Why is this theory important? 

Let’s try to understand the importance of behavioral finance through examples. Perhaps everyone remembers the Dot Bubble that happened in 2000 or another unfortunate crisis in 2007 that affected the whole world. In other words, these two are the prime examples where the traditional finance theory miserably failed to give reliable answers. It failed to predict the market. Various economists and finance experts agreed that we lacked something. 

However, behavioral finance was successful to solve the puzzle. It unraveled all the mysteries. Robert Shiller in his book predicted an IT Bubble would crash. He wrote the book “Irrational Exuberance”, published in 2000. As a result, his prediction became true and the world went through a horrible crisis. Again, he predicted the Real Estate bubble that would crash. He talked about it in his same book’s revised version that was published in 2007. He was right again.

Had he supernatural powers? No, he had the power granted by behavioral finance theory. Through these examples, it is clear how important it can be. 

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