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Behavioral Finance Theory

Behavioral finance is the study of how psychology affects the behavior of investors and financial markets. It recognizes that investors are not always rational and are influenced by cognitive biases. Traditional finance assumes investors are perfectly rational, but behavioral finance views investors as normal but subject to decision-making errors from heuristics, emotions, and social influences. Some common biases that affect financial decisions include overconfidence, loss aversion, and herd mentality. Strategies to overcome behavioral biases include focusing on logical decision-making processes rather than outcomes, and preparing, planning, and pre-committing to investment plans.

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Wanjiku Mathu
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132 views

Behavioral Finance Theory

Behavioral finance is the study of how psychology affects the behavior of investors and financial markets. It recognizes that investors are not always rational and are influenced by cognitive biases. Traditional finance assumes investors are perfectly rational, but behavioral finance views investors as normal but subject to decision-making errors from heuristics, emotions, and social influences. Some common biases that affect financial decisions include overconfidence, loss aversion, and herd mentality. Strategies to overcome behavioral biases include focusing on logical decision-making processes rather than outcomes, and preparing, planning, and pre-committing to investment plans.

Uploaded by

Wanjiku Mathu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Behavioral Finance

What is Behavioral Finance?

Behavioral finance is the study of the influence of psychology on the behavior of investors or
financial analysts. It also includes the subsequent effects 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.

Traditional Financial Theory

In order to better understand behavioral finance, let’s first look at traditional financial theory.

Traditional finance includes the following beliefs:

 Both the market and investors are perfectly rational


 Investors truly care about utilitarian characteristics
 Investors have perfect self-control
 

Behavioral Finance Theory

Now let’s compare traditional financial theory with behavioral finance.

Traits of behavioral finance are:

 Investors are treated as “normal” not “rational”


 They 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

Let’s explore some of the buckets or building blocks that make up behavioral finance.

Behavioral finance views investors as “normal” but being subject to decision-making biases and
errors. We can break down the decision-making biases and errors into at least four buckets.
#1 Self-Deception

The concept of self-deception is a limit to the way we learn. When we mistakenly think we know
more than we actually do, we tend to miss information that we need to make an informed
decision.
 

#2 Heuristic Simplification

We can also scope out a bucket that is often called heuristic simplification. Heuristic
simplification refers to information-processing errors.

#3 Emotion

Another behavioral finance bucket is related to emotion, but we’re not going to dwell on this
bucket in this introductory session. Basically, emotion in behavioral finance refers to our making
decisions based on our current emotional state. Our current mood may take our decision making
off track from rational thinking.

#4 Social Influence

What we mean by the social bucket is how our decision making is influenced by others.

Top 10 Biases in Behavioral Finance

Behavioral finance seeks an understanding of the impact of personal biases on investors. Here is
a list of common financial biases.

Common biases include:

1. Overconfidence and illusion of control


2. Self Attribution Bias
3. Hindsight Bias
4. Confirmation Bias
5. The Narrative Fallacy
6. Representative Bias
7. Framing Bias
8. Anchoring Bias
9. Loss Aversion
10. Herding Mentality

Overcoming Behavioral Finance Issues


There are ways to overcome negative behavioral tendencies in relation to investing. Here are
some strategies you can use to guard against biases.

#1 Focus on the Process

There are two approaches to decision-making:

 Reflexive – Going with your gut, which is effortless, automatic and, in fact, is
our default option
 Reflective – Logical and methodical, but requires effort to engage in actively

Relying on reflexive decision-making makes us more prone to deceptive biases and emotional
and social influences.

Establishing logical decision-making processes can help protect you from such errors.

Get yourself focused on the process rather than the outcome. If you’re advising others, try to
encourage the people you’re advising to think about the process rather than just the possible
outcomes. Focusing on the process will lead to better decisions because the process helps you
engage in reflective decision-making.

#2 Prepare, Plan and Pre-Commit

Behavioral finance teaches us to invest by preparing, by planning, and by making sure we pre-
commit. 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.”

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