Behavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners and ultimately, the subsequent effect on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.
In order to understand behavioral finance, let’s contrast it first with traditional financial theory….
Traditional finance is predicated on the belief that:
Both the market and investors are perfectly rational
Investors truly care about utilitarian characteristics
Investors have perfect self-control
Investors are not confused by cognitive errors or information processing errors
Traits of behavioral finance are:
Investors are treated as “normal” not “rational”
Investors actually have limits to their self-control
Investors are influenced by their own biases
Investors make cognitive errors that can lead to wrong decisions
Decision-Making Errors and Biases
As we’ve already talked about, behavioral finance is looking at investors as “normal” but also as being subject to decision-making biases and errors. We can break down the decision-making biases and errors into at least four buckets.
The concept of self-deception is a limit to the way we learn. By tricking ourselves into thinking we know more than we do, we are closed off to information that we need to make an informed decision.
We adopt rules of thumb instead of absorbing the entire data. In general, shortcuts serve us well, but the simplifying processes that are normally efficient time-savers can have disastrous consequences.
We all have experiences where our decisions have been influenced by whether we’re angry, sad, happy, and so on. That’s really what we are getting at – how mood affects our decision making
Financial decisions are rarely made based solely on an objective look at the numbers. People are social creatures, and therefore social factors influence actions when it comes to handling and investing money.
Biases in Behavioral Finance
One of the main breakthroughs in behavioral finance is an understanding of the impact of personal biases on investors. Below is a list of the most common biases investors are subject to, whether they know it or not.
- Overconfidence and illusion of control
- Self Attribution Bias
- Hindsight Bias
- Confirmation Bias
- The Narrative Fallacy
- Representative Bias
- Framing Bias
- Anchoring Bias
- Loss Aversion
- Herding Mentality
Overcoming Behavioral Finance Issues
Given all of the above, you may be concerned about how investors overcome these challenges. Below are two of the main strategies to guard against biases and decision-making errors.
Focus on the Process
The more we rely on reflexive decision-making, the more prone we are to self-deception biases, heuristic simplification, influences of emotion, influences of herding, and being influenced by the behavior of others.
To mitigate against reflexive decision-making, it’s important to set up processes. Consider setting up processes that guide you through a logical decision-making approach and therefore help mitigate the use of reflexive decision making.
Prepare, Plan and Pre-Commit
Behavioral finance teaches us to invest by preparing, by planning and by making sure we pre-commit. So, let’s finish with a quote from Warren Buffett.
“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.”