Behavioral finance is a theory in economics that suggests behavioral patterns and various psychological factors play a role in how investors choose to invest their money. There are certain influences and biases for example that can account for why an investor invests in one asset over another, and consequently, how that comes to impact the market as a whole. In this article, we look closer at what specifically behavioral finance entails and what are some of the influences and biases that do play into the concept of behavioral finance.
Understanding Behavioral Finance
Why do people make the financial choices that they do? Why will an investor opt to put their money into one asset class while foregoing another? These are some of the questions that behavioral finance seeks to answer from a more psychological foundation versus some other types of approaches. Subsequently, when an investor does choose to put their cash into a certain investment due in part to various behavioral factors, this then influences the stock market. We can therefore see that behavioral finance has a far broader impact than just that which concerns the individual investor. People are not just purely rational. When it comes to money matters, psychology and emotionality can play quite a large role. This is what behavioral finance seeks to explain.
More specifically, within the field of behavioral finance is the study of biases. For economic theory, such biases are divided into five categories. To better understanding financial decision-making, many experts will study these categories of bias in terms of how they influence where money gets invested.
Understanding Biases in Behavioral Finance
As noted, there are five primary categories related to biases. Biases, many agree, are largely responsible for why investors choose to buy, sell, hold, what have you. Below is a breakdown of those five biases associated with the study of behavioral finance.
Disposition bias relates to which investments a person holds onto and which they decide to sell. For those investors looking to make money quickly, they tend to sell the winners and then hold onto the losers. The reasoning behind this is fairly straightforward, by selling a stock that is doing well, they’ll realize decent returns in a short period. In holding onto stock not performing as well, they are hoping to at least get back to the breakeven point and thus not lose any money on the transaction. These investors are quick to admit they made a good choice and yet by the same token, more hesitant to admit their investment mistakes.
As far as confirmation bias, this is when an investor will readily accept information concerning a choice they’ve already made regarding their investment. That is to say, even if the information they get is flawed somehow, they will still cling to this data to confirm that their choice was a wise one.
Recent events such as the crisis of 2008 can lead some investors to make choices based upon their certainty that such an event is bound to occur again. In other words, they’ve experienced a negative event and draw upon the experience of this event to make decisions about investments moving forward. The problem here is that the experience in question is constraining them in terms of the risks they are willing to take and the assets they are willing to invest in. This could prevent them from taking advantage of a profitable opportunity.
Loss aversion is when an investor is more fearful about the potential for loss than they are hopeful about making a profit. That is to say, their anxiety regarding losing money outweighs their desire to invest in riskier assets with the potential for greater returns. In some cases, even if the risk involved seems acceptable, the investor might be clouded by their fear of taking a hit and they will consequently pass up on a great deal.
This is when investors stick with what they know. They invest money into those assets with which they are more familiar and thereby feel more comfortable making that investment. This can be a dangerous strategy because they tend not to diversify their portfolio and ultimately the risk is not as mitigated as it should be.
Behavioral Finance and the Market
While most tend to assume that investors invest using a more rational approach, there are studies out there that contradict such a theory. Behavioral elements most definitely factor into how investors approach their portfolios. From their experience with certain assets to the events that they’ve been negatively impacted by, to their risk tolerance and consequent fear of losing money, all of these are variables that help to determine an investor’s financial decision making process. And this in turn, affects the stock market in general.
Someone who studies behavioral finance does so with the understanding that external factors and psychological influences combine to make for a less than an efficient system. That is to say, if an investor were purely rational in their approach, there could potentially be less volatility. But as investors are human beings, a purely rational approach is often impossible to achieve.
Many experts do believe it is important to apply a behavioral finance lens to the study of economics in general, as it helps to paint a much more comprehensive picture of how the market works. Gaining a better understanding of behavioral trends about financial matters can help us to better gauge markets and make more accurate predictions.
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