Behavioral Finance is a field of study that studies individual and group emotions, and the impact of their behavior on the financial markets. This is a multidisciplinary field that includes clinical psychology, psychiatry, organizational behavior, behavioral economics, accounting, management and the art of judgement.
“To err is human, to forgive is Divine”, is a saying that we all have heard since our childhood. The erroneous or less than perfect human behavior also has the power to shake the investment world and asset classes. Sadly, the stock markets aren’t that forgiving.
While the traditional theory of finance states that investors are perfectly rational and follow sound logic while making investment decisions. However, this is far from truth. Investors are swayed by emotions and past experiences which can lead them to irrational investment choices. It is important for investors as well as investment managers to understand this anomaly to factor things better. This is where Behavioral Finance steps in.
What are the most common Behavioral biases that influence investment decisions?
Denial: Most of the times investors do not want to believe that the stock they have held since ages has become under-performing or they need to sell it off. They are in a constant state of denial. Even through the said asset brings the overall return of the portfolio down, investors are reluctant to part with it.
Information processing errors: Often referred to as the heuristic simplification, information-processing error is one of the biases of investor psychology. These people use the simplest approach to solve a problem rather than depending on logical reasoning. Heuristic simplification can be detrimental to the investing decisions. This is done by omitting crucial information to reduce complexity and processing only part information. Such an approach can lead to flawed decisions which can be dangerous to the stock market.
Emotions: Most of the behavioral anomalies stem from extreme emotions of the investors. This happens when investors do not make decisions with an objective mind and only tend to respond to their biases. Misconceptions, misinterpretations, risk-aversion, past experiences all combine to block the logical bent of mind and exposes the investment decisions to possibilities of risk and losses.
Loss Aversion: The risk-taking ability of each investor is different. Some are conservative in their approach while others believe in taking calculated risks. However, among the conservative investors are few who fear losses like anything. They may be aware about the potential gains from an asset class but are intimidated by the prospects of incurring even a short-term loss. In short, their excitement for gains is much less than their aversion towards losses. Needless to say these investors miss out on quite a few fruitful investments.
Social influence/ herd mentality: Herding is quite an infamous phenomenon in the stock markets and is the result of massive sell offs and rallies. These investors do not put in deep research behind their decisions and only follow the sentiment of the crowd whether positive or negative. Whether it was the tech-bubble in the early 90s, the subprime crisis in 2008, the Eurozone crisis in 2010 or the recent banking sector scams in India, the market has seen huge sell-offs. Most of them weren’t even warranted.
Framing: According to the Modern Portfolio Theory, an investment cannot be evaluated in isolation. It has to be viewed in the light of the entire portfolio. Instead of focusing on individual securities, investors should have a broader vision of wealth management. However, there are investors who single out assets or a particular investment for evaluation. This is viewing at things through a “narrow frame”. This may lead to losses. Investors need to look at the holistic picture and evaluate with a “wider frame”.
Anchoring: Many a time investors hold on to a particular belief and refuse to part ways with it. They “anchor” their beliefs to that notions and have difficulty in accepting any new piece of information related to the subject. This is true in cases wherein a real estate or pharmaceutical company is involved in a legal battle or bank has been involved in a scam. These negative information is received with greater intensity, so much so that no other piece of positive information can neutralize its effect.
Why should investment managers understand Behavioral Finance?
Understanding Behavioral Finance enables wealth managers to avoid emotion-driven speculation leading to losses, and thus devise an appropriate wealth management strategy. Behavioral finance is a sharp contrast to the efficient markets theory and establishes that markets can also be inefficient in reality. Due to these inefficiencies, there can be changes in price of assets for reasons other than fundamental factors. The role of Behavioral Finance is to empower market analysts and investors to understand price movements without the role of any fundamental changes for the company or sectors.
Investors and portfolio managers need to understand behavioral finance, not just to capitalize on stock and bond market fluctuations, but also to improve their own decision-making process.
What are the approaches to decision-making as recommended in Behavioral Finance?
Behavioral finance advocates two approaches to decision-making:
- Reflexive – Following your gut feeling and inherent beliefs. In fact this is your default option.
- Reflective – This approach is logical and methodical, something that requires a deep thought process
The more investors rely on reflexive decision-making, the more exposed they are to behavioral biases like self-deception biases, heuristic simplification, excess emotions and herding. Behavioral Finance is an in depth study on these patterns and is creating a crucial place for itself among investors and investment managers.
To mitigate against reflexive decision-making, it’s important to set up processes. Consider setting up processes that guide you through a logical decision-making approach and therefore help mitigate the use of reflexive decision making.