Behavioral finance is a field of study that considers the role of psychological factors when it comes to making financial decisions. It’s used to understand why people make financial decisions that are not always rational by combining psychology and economics to observe certain thought patterns related to finance.
Behavioral finance is important to understand as an investor because it can help you make better investment decisions. By understanding why people make the financial decisions they do, you can avoid making the same mistakes and give yourself an edge in the market.
In this article, we’ll look deeper into behavioral finances and examine different financial biases that influence financial choices as well as how to overcome them.
Behavioral finance is a field of study examining how people’s emotions and biases affect their financial decision-making and any behavioral bias in investing. It integrates insights from psychology and economics to better understand people’s financial choices and also examines the resulting effects on the market.
In other words, the field of behavioral finance probes how human psychology can have real consequences on the market’s performance.
The history of behavioral finance is generally traced back to the publication of Daniel Kahneman and Amos Tversky's paper "Prospect Theory: An Analysis of Decision under Risk" in 1979.
This paper, which introduced the concept of mental accounting, challenged the standard economic assumption that people are rational decision-makers. Kahneman and Tversky's work inspired a whole new field of research into how people actually make financial decisions.
Behavioral finance has its roots in psychology and sociology, and its early pioneers were mostly psychologists and economists. However, in recent years, the field has been increasingly interdisciplinary, with contributions from a variety of disciplines including anthropology, political science, and neuroscience.
The central question in behavioral finance is why people do not always make rational financial decisions. There are a number of explanations for this, including emotions, biases, and heuristics.
Behavioral finance research has shown that even small deviations from rationality can have a significant impact on financial decisions and outcomes.
Behavioral finance can be used to help explain a wide range of phenomena, from why people are reluctant to sell stocks that have lost money to why they are more likely to take risks when they feel good about themselves.
Behavioral finance can also be used to improve decision-making. For example, by taking into account how people are likely to respond to losses, behavioral finance can help investors design portfolios that are more resilient to market downturns.
While we traditionally think of investor decision-making to be based on a number of obvious factors, such as the condition of the market, an investor’s personal risk tolerance, taxation, liquidity, or a variety of others, behavioral psychology adds in an additional factor that can be difficult to measure.
Behavioral psychology assumes that investors aren’t without flaws. Investors can be irrational and lack self-control, which can influence their investment decisions. One of the main ways behavioral psychologists study this phenomenon is by looking at how subconscious biases affect decisions and can lead to error.
Understanding the most common personal behavioral biases and how they play a part in the investments we make is the best way to realize their impact.
Confirmation bias is the tendency for investors to seek out information that confirms their existing beliefs about a particular investment while ignoring information that contradicts those beliefs.
For example, an investor who is considering buying a stock may only look for information about the company that confirms their decision to buy, such as positive analyst reports or strong past performance. They may ignore negative information about the company, such as potential risks or challenges, leading to poor investment decisions.
Loss aversion is the tendency where people would rather avoid a loss than acquire comparable gains. Someone who is loss averse might be more likely to sell a stock when it decreases in value, even if it’s still expected to increase in the future, in order to avoid the loss.
Experiential bias is the tendency for investors to base their decisions on their own personal experiences rather than on objective data or logic. This can lead investors to make decisions that aren’t in their best interests, or that are based on flawed reasoning.
An investor who has had success with a particular investment strategy in the past may be more likely to take risks and invest aggressively, even if market conditions are not favorable. Conversely, one who has experienced losses in the past may be more risk-averse and less likely to take chances, even if the market is performing strongly.
Familiarity bias is the tendency for investors to prefer investments that are familiar to them. For instance, someone interested in investing in real estate might automatically opt to purchase a passive income property rather than consider investing in a real estate syndication, which can eventually result in greater returns and in practice, requires less of an active role compared to managing property.
The inherent bias of putting our money in places that are comfortable and familiar to us can lead to suboptimal investment decisions, as the investor might not be fully considering all of the available options.
Anchoring bias is a cognitive bias that occurs when people rely too heavily on the first piece of information they receive (the "anchor") when making decisions. For example, an investor who anchors on the price of a stock at the time they first purchase it may be reluctant to sell it later, even if the stock has declined in value because they are anchored to the original purchase price.
Sunk cost bias is the tendency for people to continue investing in something as long as they have already invested a lot of time or money, even if it’s not rational to do so. As an example, an investor might continue to hold a losing stock position because they paid a high price for it and don't want to admit that it was a mistake.
The herding mentality bias is the tendency for investors to make decisions based on the actions of other investors, rather than on their own analysis. This can lead to bad decisions, as investors may follow the herd into investments that are overvalued or risky.
Herding mentality played a role during the dot-com bubble of the late 1990s, as many investors poured money into tech stocks without doing their own research and lost a lot of money when the bubble burst.
Self-attribution bias is a cognitive bias that leads people to attribute their successes to their own abilities and their failures to external factors. For example, an investor who has made a series of successful investments might attribute their success to their own skill, while an investor who has made a series of unsuccessful investments might attribute their failure to bad luck.
This bias can lead investors to make poor decisions, such as continuing to invest in a losing stock because they believe they can turn it around, or selling a winning stock because they believe the good luck that led to the initial success will not continue.
Hindsight bias is the tendency to believe, after the fact, that one would have predicted an event that has already happened. This bias can lead investors to make poor decisions, as they may be overly confident in their ability to predict the future.
With this bias, investors may be more likely to invest in a company after it has announced positive earnings, regardless of whether or not the company was actually a good investment.
The gambler's fallacy is the belief that past events can influence future events. For example, if a coin has been flipped 10 times and landed on heads every time, the gambler's fallacy would be to believe that it is more likely to land on tails on the next flip because the gambler assumes that the coin is due for a change.
This bias can be seen in the crypto and NFT markets, where investors may believe that a certain asset will change from bearish to bullish (or vice versa) based on past events. People who fall victim to this fallacy may end up buying assets that are overvalued and likely to decrease in value, or selling assets that are undervalued and likely to increase in value.
Like in any form of personal growth, the first step is becoming aware of your own personal financial biases and the reasons behind them. Then, you can take steps to overcome these biases in order to become a better investor who makes decisions that are based on logic rather than emotion or previous experience.
Some approaches that investors can take in order to avoid errors related to their behavioral biases in investing include:
As the field of behavioral finance continues to grow, we will likely learn even more about how people make decisions when it comes to money.
Behavioral finance biases can influence our judgment about how we invest and spend our money. By understanding our inherent biases as humans, we can become better decision-makers, and consequently, better investors.
Once you’ve pinpointed your own behavioral investing biases, getting to work on correcting them will help you build a more successful portfolio.
Vyzer can help you along the way by providing you with an overview of your investments’ performance so that you can regularly monitor and compare your assets objectively. Tracking all your investments in one place can also help you regularly review your portfolio so that you can make decisions based on real data and logic rather than letting your biases guide your choices.
In addition, Vyzer’s cash flow projection feature provides you with the tools you need to ensure you’re hitting your investment goals.