Mental accounting: Mental accounting refers to the propensity for people to
allocate money for specific purposes.
Herd behavior: Herd behavior states that people tend to mimic the financial
behaviors of the majority of the herd. Herding is notorious in the stock market as
the cause behind dramatic rallies and sell-offs.
Emotional gap: The emotional gap refers to decision making based on extreme
emotions or emotional strains such as anxiety, anger, fear, or excitement.
Oftentimes, emotions are a key reason why people do not make rational choices.
Anchoring: Anchoring refers to attaching a spending level to a certain reference.
Examples may include spending consistently based on a budget level or
rationalizing spending based on different satisfaction utilities.
Self-attribution: Self-attribution refers to a tendency to make choices based on a
confidence in self-based knowledge. Self-attribution usually stems from intrinsic
confidence of a particular area. Within this category, individuals tend to rank their
knowledge higher than others.
Biases Studied in Behavioral Finance
Breaking down biases further, many individual biases and tendencies have been
identified for behavioral finance analysis, including:
Disposition Bias
Disposition bias refers to when investors sell their winners and hang onto their losers.
Investors' thinking is that they want to realize gains quickly. However, when an
investment is losing money, they'll hold onto it because they want to get back to even or
their initial price. Investors tend to admit their correct about an investment quickly (when
there's a gain). However, investors are reluctant to admit when they made an
investment mistake (when there's a loss). The flaw in disposition bias is that the
performance of the investment is often tied to the entry price for the investor. In other
words, investors gauge the performance of their investment based on their individual
entry price disregarding fundamentals or attributes of the investment that may have
changed.
Confirmation Bias
Confirmation bias is when investors have a bias toward accepting information that
confirms their already-held belief in an investment. If information surfaces, investors
accept it readily to confirm that they're correct about their investment decision—even if
the information is flawed.
Experiential Bias
An experiential bias occurs when investors' memory of recent events makes them
biased or leads them to believe that the event is far more likely to occur again. For
example, the financial crisis in 2008 and 2009 led many investors to exit the stock
market. Many had a dismal view of the markets and likely expected more economic
hardship in the coming years. The experience of having gone through such a negative
event increased their bias or likelihood that the event could reoccur. In reality, th
