Collectively, consumers tend to make bizarre choices when it comes to how they make purchases and manage their money. Similarly, investors in financial markets tend to think as a group and make irrational decisions. It’s almost uncanny how an event can trigger so many market participants to react in the same way unconsciously.
Behavioral finance theory is a response to this strange behavior. It 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’s a definite focus among financial behaviorists on the psychology of investing in particular. It’s most likely due to 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 these foolish decisions, as well as their impact on markets as a whole. They can use this information to help guide investors to make sounder decisions when investing in the stock market – or to profit themselves.
These concepts may contradict the efficient market hypothesis, and they may not allow investors 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’re 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. Daniel Kahneman’s paper “Prospect Theory: An Analysis of Decision 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 on both the individual and group levels. Modern theorists have gone to additional lengths and started doing neuro-mapping to identify parts of the brain that may be responsible for key decisions.
One interesting conclusion many researchers have proposed is that investors often make decisions that are unlikely to help them make more money or keep the wealth they already have. As counterintuitive as this may seem, there’s 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 several 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. Fear of Loss Is More Motivating Than the Rewards of Successful Investing
Investors put their money into assets so that they can make more money. However, once they’ve invested, the fear of losing their money seems to predominate in their minds.
Investors 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 investment decision and cling to it, hoping they can get their money back. That usually doesn’t happen, and they end up incurring even greater losses.
2. People Believe What They Want to Believe
People tend to ignore bad investment news and analysis, even when their money is at stake. The insanity escalates when they use 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 investors would be less confident when less information was available to them. Unfortunately, they’ve historically been easily assured by good news. When the stock market performed well, they believed it was possible to make a lot of money with little work.
4. All Dollars Are Not Treated Equally
Most people would think that a dollar is a dollar no matter how you spin it. But according to some theories and observations, that isn’t the case. People tend to place more value on a penny they’ve earned than three they could save. Also, money received through inheritances is often spent more frugally than money 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 on taxes as they do at earning it.
5. Detailed Descriptions Influence Investors More 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. That’s even the case when they aren’t looking for something specific or have no preconceptions about what they’re looking for.
6. Decisions Are Harder to Make When Consumers Have Lots of Options
Even when they’re 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. The more options they face, the harder it is for them to choose rationally.
7. People Often Use 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 known as anchoring.
One example is when investors look at the high and low price of a security for a year and assume the security will always be trading in that price range. If it’s trading on the low side, they buy it with the expectation it will increase in value. Of course, it can – and often does – move into a new low territory, leaving investors with a significant loss.
Another example is parents who obligate themselves to spend a set amount – say, 15% of their December income – on Christmas gifts, resulting in the purchase of frivolous gifts their children don’t want. As bizarre as it may sound, some parents hold themselves to such hard and fast rules.
8. Mental Accounting
Mental accounting is when people divide their money up into different accounts for subjective reasons. They may have an account to save up for their next summer vacation, one for Christmas gifts, and one for their children’s college education. This 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 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’re probably more likely to bet the coin will be heads next. They assume the law of averages works out, failing to consider that the coin is just as likely to turn up heads the next time around.
This is how many people view trading strategies 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 on prior price movements are an exercise in futility. There’s a good chance they’re 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. That’s true to an extent, but in many cases, this rationale doesn’t make any sense. Investors often look at the most current report from a group of analysts who all had access to the same information and assume it’s correct. They fail to consider that all the analysts before them looked at the same data over the same time frame but came up with different results. It’s almost as if the events or studies that came before were statistically insignificant and didn’t merit inclusion in the sample.
11. Pressure to Conform to Others’ Beliefs
People go with the flow and make the same mistakes everyone else around them makes. This is due either to a need for acceptance or the inability to accept that large groups can 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.
Applications of Behavioral Finance Theory
There are several ways financial advisors and individuals can use the lessons of behavioral finance to their advantage:
1. Learning to Recognize Mistakes
There are several mistakes 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’d have to work to earn $100 and how easy it would have been to get that money off the ticket price. I placed more value on the money I would have earned than saved.
Others might not realize they always make investment decisions based on limited knowledge. After they’re made aware of this, they may notice it in themselves and take steps to fix it.
2. Understanding and Utilizing Others’ Decision-Making Processes
In addition to recognizing people’s mistakes, it’s sometimes important to understand people and the way they think in general.
When money managers understand their clients’ behavior, they can give them better advice. In confrontational situations, such as legal settlements, many professionals play to the other party’s weaknesses using behavioral finance to ensure 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 market 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 attempt to predict significant variables, such as the number of units of a particular product they’re likely to sell under a given set of circumstances. It’s key to understanding financial models.
Many forecasters find their numbers are off because they erroneously assumed consumers or investors would behave rationally. Predicting how consumers and investors will act, rather than how they should act, leads to more accurate forecasts and models.
5. Understanding the Impact of Events on the Market
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 they can use it to influence others strategically. While it could be considered unethical, companies regularly study the decision-making errors of consumers to find out how they can exploit these errors to convince consumers to purchase their products.
Keep in mind that some of these concepts contradict the efficient market hypothesis, which you should not necessarily discount entirely. There’s evidence to suggest that concepts such as technical analysis are valid trading tools. They’re based on the logical concept that human beings tend to follow behavioral patterns not always apparent 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, there have been many great books and papers written on the subject in recent years. The topic is so complex it’s impossible to summarize all the theories and ideas here. The works of Adam Smith and Jeremy Bentham helped found the field, but they are older pieces that don’t serve consumers or investors as well as more recent research.
The following resources will help you learn more about the psychology behind financial decisions and how you may be able to use it to your advantage when investing.
- BehaviouralFinance.net. This blog is dedicated solely to the topic of behavioral finance. It attempts to discuss everything relevant to behavioral finance and does a great job doing so.
- “The Courage of Misguided Convictions.“ Brad Barber wrote an excellent paper on the trading strategies of individual investors and how they relate to us.
- “The Disposition Effect in 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.
- “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 poorly. The effect of this practice is that the security continues to move in the same direction.
Professionals have been researching the field of behavioral finance for years. It has given us 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.
Supporters of the efficient market hypothesis may not believe in all strategies behind behavioral finance. Still, at the very least, you can use these principles to notice your own errors and do what you can to fix them. If you’re interested in learning more about the mistakes 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?