Behavioral Finance How Psychological Factors can Influence the Stock Market

Introduction

The era that we live in is called the ‘information age’ – and for a good reason. Never before have people had such instantaneous, easy access to so much information. The abundance of information might seem to be beneficial to us in getting informed and making good decisions, but the availability of so much information does not necessarily make us knowledgeable; in fact, it might actually be overwhelming and hamper decision making. Judgmental heuristics, or mental shortcuts, are thus a natural reaction that allows us to process complex information and arrive at conclusions more rapidly. However, not only are these conclusions often faulty, we may even believe we have gained substantial levels of knowledge when viewing the conclusions as correct. An investment professional that can systematically recognize and address incorrect uses of heuristics in financial decision-making is much better equipped not only to improve his or her own decisions but also, crucially, to help clients achieve their goals. So far, the traditional approach to finance and investment has mostly worked with financial markets and financial decision making under the elementary economic assumption of rationality and efficiency of markets and their participants, and it has been able to explain some of the behaviors in this way. However, more and more inconsistencies appear that the traditional finance paradigms are unable to either predict or explain, and even the initial assumptions of these theories are problematic – the assumption of rationality, while useful for simplifying the situation and making it easier to analyze and understand, is just not there in real life.

The mechanism of incentive and fear make investing an inherently emotional process. In the last years, though, finance has seen a 7 emergence of a new way of thinking about financial decision making that takes into account the psychology of the investor – heuristics, biases, emotions, fears, fallacies – to make sense of investor decision making. Behavioral finance is a relatively new field that enters the discussion as an alternative approach working with emotion and decision-making flaws to see how these prevent us from achieving optimal results in investing and how they can be worked with to optimize the results.

Behavioral finance is a powerful tool not only in understanding the deeper intuitive causes of some of our behaviors related to financial decision making, but also, and most importantly, in addressing these effects daily, as it empowers investment professionals to gain a deeper understanding of the drivers of their decisions and those of their clients, and to apply this knowledge in their professional practice to achieve better, more rational decisions; for this reason, behavioral finance should see a broader application in the everyday practice of finance professionals for the industry to generate more positive outcomes.

Behavioral finance is a combination of psychology and economics and it attempts to explain investors’ behavior and the psychological factors behind their investment decisions and what effects they have on financial markets. The field of finance has long been based on the idea that markets are efficient, and investors are rational with theories such as the efficient market hypothesis and the capital asset pricing model. The efficient market hypothesis entails that the market is unbeatable and economic agents are fully rational, the latter implies that information is fully reflected in market prices. This theory states that a market of this type does not permit arbitrage to take place. The Capital Asset Pricing Model describes the relationship between systematic risk and expected return of a security, it entails that investors’ expected return is that of the free risk security plus a premium for the systemic risk taken as measured by Beta. It assumes market equilibrium that emerges from the market and investors’ behavior.

However, skepticism has arisen since behaviorists have started researching the psychological and cognitive factors behind investment decisions and remark that investors may not be as rational as suggested by conventional theories. Market bubbles are thought to be caused by