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Advances in Behavioral Finance Theory & Economics

By Kalen Smith

market puzzledCollectively, consumers tend to make some very strange choices when it comes to how they make purchases and manage their money. Similarly, investors in financial markets also tend to think as a group and make irrational decisions. It is almost uncanny how an event can trigger so many market participants to unconsciously react in the same ways.

Behavioral finance is a response to this strange behavior. The theory attempts to explain how investors process events and formulate decisions. Theoretically, understanding behavioral finance allows other investors to predict market movements and profit from them.

While consumers tend to make a lot of the same mistakes investors do, there is a definite focus among financial behaviorists on the psychology of investing in particular.  This is most likely due to the widespread fascination with the activity of financial markets. In the future, this focus may shift, allowing advances in the science to also help consumers learn from their mistakes and make better financial decisions.

In addition to sometimes making poor decisions, consumers and investors have a tendency to follow each other into precarious financial situations. Behavioral finance theorists try to track the foolish decisions they make, as well as their impact on markets as a whole. They can use this information to either help guide investors into making sounder decisions when investing in the stock market, or to profit themselves.

These concepts may contradict the efficient market hypothesis , and may not really give investors the opportunity to profit from subsequent market movements, but they can still help guide investors into making better investing decisions.

Below is a crash course in behavioral finance and how it can work for you.

Foundations of Behavioral Finance

In the classical era, both Adam Smith and Jeremy Bentham wrote detailed observations on the implications of the psychology of money. Many researchers lost interest in the idea of using psychology in finance until the second half of the 1900s, when there was more evidence to support it.

Behaviorists and financial theorists alike have started to research the topic more fully in recent years. They are trying to understand how people think when they make investment decisions, and what models they can construct to use this information to their own advantage. Kahneman’s paper “Prospect Theory: Decision Making Under Risk” is probably one of the most significant in modern times.

Earlier studies were more empirical. They conducted observations on key events and measured responses both on the individual and group level. Modern theorists have gone to additional lengths and actually started doing neuro-mapping to identify parts of the brain that may be responsible for key decisions.

One interesting conclusion that many researchers have proposed is that investors often make decisions that are clearly unlikely to help them make more money or keep the wealth they already have. As counterintuitive as this may seem, there is actually a lot of evidence to support it.

To better understand where these theories and conclusions come from, let’s take a look at some of the findings in the field of behavioral finance.

Observations in Behavioral Finance

Researchers have made a number of interesting observations in this field over the years. They’ve thoroughly documented each and proposed that the following can be used as indicators of future behavior.

  1. Investors are more motivated by the fear of loss than the rewards of successful investing. Investors put their money into assets so that they can make money. Interestingly, once they’ve invested, the fear of losing their money seems predominate in their minds. Investors will often hold onto a losing asset out of pride. Even when the asset continues to decline in value, they refuse to admit they made a poor investing decision and cling to it, hoping they can get their money back. This usually won’t happen and they end up incurring even greater losses.
  2. People believe what they want to believe. People have a tendency to ignore bad investment news and analysis, even when their money is at stake. The insanity escalates when they utilize completely useless and irrelevant information to support the decision they want to make. Successful investors know to look at things objectively and refrain from being overly optimistic when making a decision.
  3. Investors are often overconfident when they have small amounts of information. Rationally, you would assume that investors would be less confident when less information was available to them. Unfortunately, they have historically been easily assured by good news. When the stock market performed well, they believed that it was possible to make a lot of money with little work. Hopefully, with recent events, this trend has changed a little. However, when the stock market recovers, this bias will probably become evident once again.
  4. All dollars are not treated equally. Most people would think that a dollar is a dollar no matter how you spin it. According to some theories and observations, this isn’t the case. People actually tend to place more value on a penny they’ve earned than three they could save. Also, money that is received through inheritances is often spent more frugally than money that the beneficiary would otherwise work hard for. Wise people manage their money the same regardless of where it comes from. They also work just as hard at saving money in taxes as they do earning it.
  5. Detailed descriptions have greater influence on investors than boring, but more relevant facts. People are often more influenced by a five page report with fancy graphics than a set of hard data. The few pieces of data may be more relevant and beneficial in making a decision, but lengthy and engaging reports seem to have a stronger effect on many people. This is even the case when they aren’t looking for something specific, or have no preconceptions about what they are looking for.
  6. Consumers have a hard time making decisions with lots of choices. Even when they are purchasing almost identical products at similar prices, consumers are often paralyzed when it comes to making a decision. Many times, they make random choices rather than evaluate the products to make an informed decision.
  7. Using an arbitrary or irrelevant metric to assign value. Investors and consumers frequently come up with a random way to determine the value of a security or good. This concept is referred to as anchoring. One example is when investors look at the high and low price of a security for a year and assume that the security is always going to be trading in that price range. If it is trading on the low side, they will buy the security with the expectation that it will increase in value. Of course, it can always move into new low territory (and often does), leaving investors with a significant loss. Another example is when parents obligate themselves to spend 15% of their December income on Christmas gifts, resulting in the purchase of frivolous gifts their children won’t want. As bizarre as it sounds, some parents actually hold themselves to these hard and fast rules.
  8. Mental accounting. This is when people divide their money up into different accounts based on subjective reasons. They may have an account to save up for the next summer vacation, one for Christmas gifts, and one for their children’s college education. This strategy may help them feel more organized, but it can lead to inflexible financial planning and the reluctance to transfer money from a low yielding account to a more lucrative one.
  9. Gambler’s fallacy. Humans tend to be overconfident and completely illogical when predicting random, future events. One mistake they make is thinking that past events have any connection to future events. For example, if someone flips a coin twice and it turns up tails each time, they are probably more likely to bet that the coin will be heads next. They assume that the law of averages works out, failing to consider that the coin is just as likely to turn up as heads the next time around. This is how many people view trading strategies that are based on random price movements. It also accounts for the difficult time people have profiting from technical analysis trading strategies and the doubts many financial professionals have about technical analysis itself. They claim that the market has no memory and that attempts to predict it based off of prior price movements is an exercise in futility. There is a good chance they are right.
  10. Placing more emphasis on recent events rather than considering all events together. People assume that recent and relevant events go hand in hand. This is true to an extent, but in many cases the rationale doesn’t make any sense. You will find that investors will often look at the most current report from a group of analysts who all had access to the same information and assume that it is the correct one. They fail to look at the fact that all the analysts before them looked at the same data, over the same time frame, but came up with different results. It is almost as if the events or studies that came before were statistically insignificant and didn’t merit being included in the sample.
  11. Pressure to conform to others’ beliefs. People go with the flow and make the same mistakes that everyone else around them make. This is either due to a need for acceptance or the inability to accept that large groups can possibly be wrong.

These are some of the most commonly recorded phenomenons in behavioral finance. They have been observed over periods of decades or centuries. Behaviorists and financial researchers are constantly looking for more subtle and benign examples of how psychology impacts financial decisions, and how we can use this information to our advantage.

Now that you understand the patterns that support the theory, how can it be applied? Fortunately, this research can easily be used to inform real life decisions.

Applications of the Behavioral Finance Theory

There are several ways that financial advisors and individuals can use the lessons of behavioral finance to their advantage:

  1. Learning to recognize mistakes. As mentioned above, there are a number of mistakes that investors and consumers make time and time again. Understanding behavioral finance allows them to notice their mistakes and rectify them. For example, I noticed when I was buying a car recently, that I wasn’t too motivated to negotiate the price down, even though I could have easily gotten a hundred dollars off of the sale price. Afterward, I was kicking myself thinking how hard I would have to work to get that $100 and how easy it would have been to get that money off the ticket price. I clearly placed more value on the money I would have earned than saved. Other investors might realize that they constantly make decisions based on limited knowledge. After they are made aware of this common heuristic, they may notice it in themselves and take steps to fix it.
  2. Understanding and adapting to other people’s decision making processes. In addition to recognizing people’s mistakes, it is sometimes important just to understand people and the way they think. It is ideal for money managers to understand their client’s behavior so that they can give them better advice. In confrontational situations (such as legal settlements), many professionals will play to the other party’s weaknesses using behavioral finance in order to ensure that they get the better end of the settlement. This is commonly referred to as game theory.
  3. Evaluating market trends. Behavioral finance is the concept behind understanding markets trends, because these trends are the basis for how people make financial decisions. One application is through the use of technical analysis, which involves using charts and graphs to predict future price movements. The principle behind technical analysis is that humans rely on both conscious and subconscious patterns when investing. Those patterns can be followed and used to predict other future behavior.
  4. Facilitating the planning process. Forecasters are able to predict significant variables such as the number of units of a particular product they are likely to sell under a given set of circumstances. This is key to understanding financial models. Many forecasters find their numbers are off because they erroneously assumed that consumers or investors would behave in a rational manner. Predicting how consumers and investors will behave rather than how they should behave will lead to more accurate forecasts and models.
  5. Impacts of events on the market. Typically, following long standing trends (such as price patterns over the course of a month or more) is a popular idea among trenders and technical analysts, but financial planners can track security prices based on one time events as well. Human beings are expected to react a certain way after an event and this information can be used to their advantage.
  6. Promoting products to consumers. In a lot of ways, behavioral finance overlaps with marketing. They both rely on the psychology of individuals and groups, and how it can be influenced through strategically influencing others. While it could be considered unethical, companies regularly study the decision-making errors of consumers to find out how they can be exploited to convince consumers to purchase their products.

Keep in mind that some of these concepts contradict the efficient market hypothesis, which should not necessarily be completely discounted. There is evidence to suggest that concepts such as technical analysis are valid trading tools. They are based off of the logical concept that human beings tend to follow behavioral patterns not always obvious to the majority of investors. Therefore, it may still be possible to profit from them.

Additional Resources on Behavioral Finance

If you’d like to learn more about behavioral finance, you’re in luck. There have been a lot of great books and papers written on the subject in recent years. The topic is so complex that it is impossible to summarize all the theories and ideas in a blog article or even an entire blog devoted to the topic. The works of Adam Smith and Jeremy Bentham helped found the field, but they are older articles that don’t serve consumers or investors as well as more recent research. Here are some resources you may want to look at:

  1. BehaviouralFinance.net. This blog is completely dedicated to the topic of behavioral finance. It attempts to discuss everything relevant to behavioral finance and does a great job doing so.
  2. The Courage of Misguided Convictions. Brad Barber wrote an excellent paper on the trading strategies of individual investors and how they relate to us.
  3. The Disposition Effect of Securities Trading. Based on empirical studies of securities trading, this paper focuses on the tendency of investors to hold onto losing assets and sell those that have made the most money.
  4. The Disposition Effect and Momentum. This paper illustrates the phenomenon of investors continuing to invest in securities that have performed well or dumping those that have done very poorly. The effect of this practice is that the security continues to move in the same direction.

These resources should help you learn more about the psychology behind financial decisions and how you may be able to use them to your advantage when investing.

Final Word

Professionals have been researching the field of behavioral finance for years. It has given new insight that can change the way we participate in markets and better understand consumers. Studying the psychology of consumers and investors can be a great way to both observe investing opportunities, and correct investing mistakes. It is something that should be researched carefully.

Supporters of the efficient market hypothesis may not believe in all strategies behind behavioral finance, but at the very least, you can use these principles to notice your own errors and do what you can to fix them. If you are interested in learning more about the mistakes that investors and consumers make, try checking out some of the papers that academics and researchers have written. You may be surprised by the errors you make yourself.

What are your thoughts on the behavioral finance theory? Could you relate to any of the behaviors listed above? Feel free to discuss your ideas and experiences in the comments below.

(photo credit: Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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Comments

  • http://barbarafriedbergpersonalfinance.com Barb Friedberg

    Kalen, You hit it out of the park. This is an exceptional article with comprhensive coverage of this important subject. The “mental accounting” error is one of my favorites. I was actually “taught” this misguided notion by a relative as a teen! Nice work, Barb

  • http://www.wholeinvestor.com Paul Puckett

    Kalen,

    I agree with Barb’s comment that you hit it out of the park. I’ve got a book coming out in a few weeks supported by behavioral economic research and have done a lot of reading and research in that area. You summarized a great deal of information in an easy to understand and relatively short article. That ain’t easy, well done! Paul Puckett, Author-Investiphobia: Overcome Your Deepest Investment Fears

    ps. If you’d like a copy to review, let me know and I’ll send you a complimentary autographed copy in April.

  • http://www.engineer-a-business.com Kalen

    Thank you Barb and Paul. I am glad that two such knowledeable investors read my post. I would love to review your book Paul. I am sure Money Crashers would love to hear what you have to say on the topic!

  • http://www.moneycrashers.com Kalen Smith

    Thanks Paul and Barb. Really glad you found the piece so useful!

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