What is Behavioral Finance?

Defining Behavioral Finance

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Quick answer: Behavioral finance is an area of study which looks at how psychological influences might influence market outcomes. Behavioral finance helps with understanding customers across sectors.

An aspect of behavioral economics, behavioral finance is an area of study, committed to exploring the impact psychological factors, influencers, and biases might have on financial behaviors.

In behavioral finance, experts look at the aspects of psychology which can lead to a range of financial outcomes in a host of industries and sectors. One of the main focus points of behavioral finance is the study of “psychological bias”.

Experts believe studying behavioral finance can help to explain various types of market changes, and anomalies in the stock market.

What is Behavioral Finance?

There are a number of angles to behavioral finance. Stock market returns are an area where psychological behaviors are frequently assumed to impact market outcomes and returns. However, there are also various other angles to consider.

Ultimately, the purpose of behavioral finance is to attempt to understand why people make certain financial choices, and how those choices influence the markets. The assumption is that financial participants in a transaction are psychologically influenced. When people are under financial stress, it affects physical and mental health, and vice versa.

Concepts in Behavioral Finance

The study of behavioral finance has led to a number of discoveries over the years. For instance, biases are a strong focus area of behavioral finances. There are five main concepts often considered by behavioral finance include:

  • Mental accounting: The propensity for people to allocate money for certain purposes.
  • Herd behavior: The tendency to mimic the behaviors of the “majority” in finance. This is common in the stock market.
  • Emotional gap: Decision-making based on emotional strains such as anger, anxiety, excitement, or fear. Emotions are the key to less rational choices.
  • Anchoring: Assigning a spending level to a certain reference. For instance, spending consistently based on budget level.
  • Self-attribution: A tendency to make decisions based on an overconfidence in one’s skill or knowledge level, usually stemming from a talent in a specific area.

Biases Considered by Behavioral Finance

As mentioned above, biases are a common point of focus in behavioral finance. Individual biases and tendencies are often identified for behavioral finance analysis, such as:

  • Confirmation bias: When investors have a bias to accept information that confirms their beliefs about an investment opportunity.
  • Experiential bias: When an investor’s memory of recent events leads them to believe the event is more likely to happen again. For instance, the crisis in 2008 pushed many investors to leave the stock market because they expected more economic hardship in the years ahead.
  • Loss aversion: When investors place greater weight on the concerns about losses than the benefits of market gains. This means investors assign a higher priority to avoiding losses, which might mean missing out on other opportunities.
  • Familiarity bias: When investors focus on investing in what they know, such as locally-owned or domestic investments. This can often lead to a lack of diversification across multiple kinds of investments, which can lead to more risk.

Behavioral Finance in the Stock Market

Behavioral finance is often a point of focus in the stock market. The “EMH”, or Efficient Market Hypothesis, says at any given time in a liquid market, stock prices are valued to reflect the available information. However, studies often document long-term changes in securities market which contradict this hypothesis, suggesting investor rationality is more complex than we think.

The EMH is based on the belief that participants in the market view prices rationally based on all future and current external and intrinsic factors. Alternatively, when studying the stock market, behavioral finance believes markets are not totally efficient, which allows for the observation of how psychological and social factors might influence the buying and selling of stock.

An understanding and use of behavioral finance biases can apply to stock market and other trading market movements on a regular basis. Broadly, behavioral finance theories have also helped to provide a clearer explanation of substantial anomalies in the market, like deep recessions and bubbles. While not a component of EMH, portfolio managers and investors usually have an interest in getting to know the trends and factors of behavioral finance.

The more you know about behavioral finance in the stock market, the easier it is to analyse market price levels, and changes for decision-making.

What Can we Learn from Behavioral Finance?

Behavioral finance tells us how financial decisions are influenced by a range of different concepts, from cognitive bias to perception of the financial markets. Everything from your investment decisions to your choices regarding financial planning and personal debt, are dependent on a range of factors, beyond simply the price of an item.

The concept of behavioral planning for financial decision-making is an alternative to “mainstream financial theory”. The mainstream financial theory suggests human beings aren’t predisposed to irrational behavior caused by emotion. This concept in heuristics also believes markets aren’t influenced by inefficiencies and unpredictable issues.

Clearly, while customers can make rational decisions, traditional finance assessments based on mainstream theory are too narrow. Psychology tells us decisions about mutual funds, investment, and more are based on a range of perceptions and cognitive errors.

The decision-making process can be influenced by everything from overconfidence bias, to hindsight bias. The average economist can benefit from this knowledge of human behavior and investment behavior.

Understanding Behavioral Finance

When we understand how, why, and when people are most likely to deviate from rational expectations, behavioral finance provides blueprints to help us make more rational decisions regarding money management in the real-world.

Financial professionals use concepts of self-control and bias in the investing environment to ensure they’re making the right decisions based on the volatility of the market.

Even with an understanding of behavioral finance, there’s no guarantee any one decision in the financial market will always pay off. However, the right insights into human behavior can make the market a little more predictable for those involved.

Rebekah Carter

Rebekah Carter is an experienced content creator, news reporter, and blogger specializing in marketing, business development, and technology. Her expertise covers everything from artificial intelligence to email marketing software and extended reality devices. When she’s not writing, Rebekah spends most of her time reading, exploring the great outdoors, and gaming.

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