A quick overview of Behavioral Finance
What is behavioral finance?
Behavioral Finance is an investment and research field that emerged in the 1990s after finance shifted away from the Efficient Market Hypothesis, which holds that a security’s price equals its fundamental value which is the discounted sum of expected future cash flows, to a new field known as behavioral finance.
Behavioral finance sharply contradicts with much of the Efficient Market Hypothesis and describes finance from a broader perspective that includes psychology and sociology. It shows that some stock market patterns are not easily explained by rational asset pricing models. Behavioral finance is built on the assumption that not all human behavior is rational and helps to explain market anomalies, so to say mispricing’s, which are created by irrational behavior, so called biases. There are different biases that lead to anomalies, that will be described below.
Overconfidence in Trading
Overconfidence is the tendency of investors to consistently overestimate their abilities as well as the accuracy of their judgements. They consider their own knowledge to be superior and overweight their private information. This leads investors to overestimate their own stock picking skills, so that they trade much more frequently and invest in overvalued stocks, which leads to mean reversion in the long run and underperformance.
Connected to this behavior, there is the self-attribution bias, which describes the tendency of individuals to attribute good results to their own high ability and bad results to bad luck or sabotage. In combination with the overconfidence bias this leads to excessive trading, under-diversified portfolios, and underestimated risk factors.
Financial cognitive dissonance
Cognitive dissonance is a psychological phenomenon which describes the distressing emotion that results from holding two contradictory cognitions (ideas, beliefs etc.) at the same time, such as a discrepancy between empirical evidence and past choice. Consequently, people tend to alter their beliefs to reduce this discomfort, resulting in irrational decision-making. Research on investors have shown that when investors must face complex and ambiguous information, they tend to overstate the strength of confirmatory information and downplay the reliability of contradictory information. In particular, when processing available information is costly so that some selection of information must be made, an investor might selectively ignore information about his or her asset.
Regret theory in Investing
The regret theory describes the desire of decision makers to avoid consequences that in retrospect reveal that they made a wrong decision, even if the decision seemed right with the information available at the time. For example, investors defer selling positions that have lost in value because they would then have to admit that they made a bad investment decision. In addition, investors often find it easier to buy popular assets that have done well in the recent past, making it easier to rationalize their investment decision if the position loses value because they simply followed the crowd. The latter behavior, also known as feedback trading, can lead to a large divergence between market prices and fundamental values and if not interrupted, it can cause speculative bubbles like the tulip bubble in Holland in the 1630s.
Prospect theory
Kahneman and Tversky's prospect theory states that decision makers value gains and losses differently. They are much more sensitive to perceived losses than to the equivalent of perceived gains. The result is the disposition effect, which says that losses weigh twice as much as gains. More precise, it means that individuals tend to sell winning stocks too early and hold on to losing stocks for too long, which results in another market anomaly.
Anchoring for Investors
When making estimates, people often start with an initial, possibly arbitrary value (anchor) that is adjusted to obtain the final answer. This initial value is often based on a single fact or figure, which may be the result of insufficient computations. In other words, people "anchor" themselves too much to the original value. For investors that means that they rely only on a few pieces of initial information and are not open to new information that would change their assumptions. In addition to that, there is the recency effect, where recent events are weighted too heavily in decision making. That means for investors that they put too much weight on the past performance of stocks, which leads to further buying when prices rise and then market anomalies in the form of overvaluation take place.
Summary
Summing up, investors should pay close attention to the described biases in order to avoid doing them. Moreover, investment strategies can be applied, that exploit market anomalies. One of them is to use social sentiment for trading. Sign up for our newsletter to access AI-powered investment insights, including our sentiment analysis!
