Personal Finance

Why Is Behavioral Finance Important

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 11 minute read

As a group, shoppers have a strange penchant for making irrational decisions about their spending and saving habits. Investors in the financial markets also tend to act irrationally as a herd. It’s eerie how a single occurrence can cause so many traders to respond in the same way, without even realizing it.

A new field of study, behavioral finance theory, was developed to explain and explain away this peculiar pattern of investing. It aims to shed light on the thought processes and decision-making procedures of investors. Theoretically, other investors can anticipate market moves and profit from them if they have a grasp of behavioral finance.

Even though investors and consumers alike are prone to the same behavioral pitfalls, financial behaviorists place a special emphasis on the mindset required for successful investment. 

The widespread interest in the workings of the financial markets is probably to blame. Perhaps this will change in the future, with scientific progress then also assisting consumers in gaining wisdom from their errors and making more informed monetary choices.

Consumers and investors alike often make bad choices and can lead each other into the risky financial territory. Behavioral finance theorists observe these irrational choices and their effect on the market. They can utilize this data to aid others in making wiser stock market investments, or use it to their own advantage.

The efficient market theory may be at odds with these ideas, and investors may be unable to profit from subsequent market fluctuations. However, they are still useful in assisting investors in making more informed choices. Learn the basics of behavioral finance and how it can benefit your investing strategy below.

Building Blocks of Behavioral Finance

Adam Smith and Jeremy Bentham, two classical authors, have made in-depth insights into the consequences of money’s psychology. Before the second half of the twentieth century, when there was more data to support it, many academics had lost interest in the idea of applying psychological principles to the financial sector.

In recent years, researchers from both behavioral economics and conventional economics have begun to delve deeper into this area. Specifically, they are attempting to learn what factors influence people’s investing choices so that they can use that knowledge to their benefit in the form of mathematical models. 

One of the most important recent works is “Prospect Theory; An Analysis of Decision Under Risk,” written by Daniel Kahneman.

The earlier research was more empirical. They watched for significant occurrences and assessed people’s and groups’ reactions to them. Neuro-mapping has been used by contemporary theorists in their pursuit of the brain regions thought to be responsible for making deliberate choices.

Researchers have come to several fascinating conclusions, one of which is that investors frequently make choices that are unlikely to help them acquire more money or keep the riches they already have. It goes against common sense, but there is substantial data to back this up.

Let’s look at some results in the discipline of behavioral finance to see where these theories and conclusions are based.

Behavioral Finance Observations

Over the years, researchers in this area have discovered a number of fascinating discoveries. They’ve kept meticulous records on everything and offered the following as potential predictors of future actions:

1. The Rewards of Successful Investing Are Not as Motivating as the Fear of Loss

When people invest their money, they do it with the hope of increasing their wealth. However, after they’ve put their money down, the worry about losing it takes center stage.

Pride causes many investors to cling to a lost investment. They continue to hold on to the asset, despite its falling worth, in the vain hope that it would eventually recover its value and restore its initial investment. In most cases, though, that doesn’t work, and they wind up losing even more money.

2. Individuals Adopt Beliefs of Their Own Free Will

Even when their savings are on the line, investors often choose to overlook negative reports and forecasts. Using meaningless or irrelevant data to back up a conclusion they already have in mind only makes things crazier. 

Successful investors know to take a balanced, realistic view of the situation rather than relying on wishful thinking.

3. Investors Are Frequently Overconfident When They Have Limited Data.

Logic would suggest that when fewer details are accessible, investors will be warier. In the past, good news has been too quickly accepted, unfortunately. At times when the stock market did well, they fantasized about getting rich quickly with little effort.

4. Not All Dollars Are Handled the Same

The average person would probably agree that a dollar is a dollar regardless of how you look at it. A number of hypotheses and empirical findings, however, suggest otherwise. A person’s earned penny is worth more to them than three saved pennies. 

Furthermore, inheritors tend to be more frugal with their inherited funds than they would be with earnings from regular employment.

It doesn’t matter to a person of discernment how their financial resources were acquired, they would handle it the same way. They put just as much effort to minimize their tax liability as they do to increase their income.

5. In-depth Descriptions Have a Greater Impact on Investors Than Boring (But More Valuable) Facts

A five-page report with pretty pictures can have more of an impact than a stack of numbers on most people. Many people appear to be more influenced by lengthy and interesting reports, even though the few pieces of facts may be more important and helpful in making a decision. 

That holds true even if they aren’t on the lookout for anything in particular and/or don’t have any expectations going in.

6. When Consumers Have a Lot of Options, Making Decisions Can Be Challenging.

Consumers are often unable to make a choice, even when faced with two almost identical products with comparable prices. They frequently select products at random rather than carefully considering their options. More choices make it difficult for them to make good decisions.

7. When determining value, People Frequently Use Arbitrary or Irrelevant Metrics

The valuation of a security or product is often decided by investors and buyers using completely arbitrary metrics. Anchoring is the name given to this mental process.

A common fallacy is that a security’s high and low prices over the course of a year are indicative of its future trading range. They anticipate a rise in price and hence purchase it if it is trading at a discount. Naturally, it can and does drop to new lows, causing investors to lose a lot of money.

Another common scenario involves parents who promise themselves they’ll spend a certain percentage of their December income on Christmas presents for their kids but end up buying them useless trinkets instead. However strange it may sound, there are parents who strictly adhere to a set of guidelines.

8. Mindfulness Accounting

People often use mental accounting to categorize their finances for various reasons. They may have a savings account for their next summer getaway, another for holiday shopping, and yet another for their children’s future university education. 

This may make individuals feel more in control of their lives, but it might make their budgets less adaptable and make them reluctant to move money from a low-yielding account to a higher-yielding one.

9. The Gambler’s Fallacy

When attempting to forecast the outcomes of uncertain occurrences, humans are often overconfident and irrational. They err in their reasoning if they assume that the past can predict the future.

If a person flips a coin twice and it always lands on its tail, they are more inclined to wager that the following time it will be heading. They think the coin always lands on heads, ignoring the fact that the odds are the same each time.

Numerous investors have this opinion about trading methods that rely on unpredictable market fluctuations. This explains why so few people make money with technical analysis trading tactics and why so many experts in the financial sector are skeptical of the methodology. 

They argue that it is pointless to try to anticipate future price movements based on past ones because the market does not remember them. It’s possible that they’re correct.

10. Emphasizing Recent Events More So Than Taking Them All Into Account.

In general, people make the connection between what has happened recently and how important it is. The statement is partially correct, however, the reasoning behind it is flawed in many situations. 

Investors typically take at face value the most recent report from a team of analysts who have all had access to the same data. They don’t take into account that previous experts have examined the same data set over the same time period and drawn different conclusions. 

It’s almost as if what came before didn’t matter enough to warrant being included in the data set, be it occurrences or research.

11. The Pressure to Share Others’ Beliefs

Humans have a tendency to follow the crowd and repeat the blunders of others around them. This occurs either because of an individual’s drive to be liked or because of an individual’s incapacity to believe that widespread opinions can be incorrect.

In the field of behavioral finance, these are among the most often observed phenomena. We know this because we have been keeping track of them for decades, if not millennia. 

Researchers in the fields of behavioral economics and finance are always on the lookout for new, more subtle examples of the ways in which human psychology influences economic decisions.

Behavioral Finance Theory Applications

Financial advisors and their clients can benefit in a number of ways by studying the principles of behavioral finance.

1. Acquiring the Ability to Spot Mistakes

Investors and shoppers alike tend to repeat the same errors over and over. The ability to recognize and correct errors are greatly enhanced by knowledge of behavioral finance.

When I bought a car lately, for instance, I wasn’t too driven to bargain the price down, even though I could have saved myself a hundred dollars by doing so. I felt like such a fool afterward, considering how hard it would be to earn $100 and how simple it would have been to deduct that amount from the price of the tickets. 

This potential income was more important to me than any savings I might have made. It’s possible that people who routinely make poor investing judgments don’t even realize it. Once people know about it, they might be able to see it in themselves and work to improve it.

2. Recognizing and Using the Decision-Making Processes of Others

It’s not always enough to just see the errors in others’ reasoning; sometimes you have to be able to put yourself in their shoes. Financial advisors can better serve their clients’ best interests when they have a firm grasp on their client’s individual personalities and investing styles. 

Many experts, while settling disputes or litigating cases, may use behavioral finance to exploit the opposing party’s vulnerabilities in order to increase their own bargaining power. The term “game theory” is often used to refer to this situation.

3. Examining Market Trends

Financial decisions are grounded in market movements, thus comprehending these trends is central to the concept of behavioral finance. Technical analysis, which makes use of such tools as charts and graphs to foretell price fluctuations in the future, is one such use. 

Technical analysis is based on the idea that investors make use of both conscious and unconscious tendencies. That behavior can be analyzed for trends and then utilized to foretell other actions.

4. Enable the Planning Process

The goal of a forecaster is to estimate future outcomes of crucial factors, such as the expected demand for a product. Financial modeling relies on this concept heavily.

Many economists and stock market analysts get it wrong because they incorrectly expect that consumers and investors will act logically. More reliable forecasts and models result when trying to predict actual consumer and investor behavior rather than ideal behavior.

5. Recognizing How Events Affect the Market

Trenders and technical analysts both are fond of the concept of riding out long-term trends, such as price patterns spanning multiple months. 

However, investors can also get updates from their financial planners on the price of a security based on a one-time event. Knowing how others will respond after an event can give one an advantage.

6. Educating Consumers About Products

There is a great deal of overlap between behavioral finance and marketing. Both rely strategically on understanding and appealing to people’s psyches in order to achieve their goals. 

Although it may not be morally acceptable, businesses frequently investigate consumers’ faulty reasoning in order to find ways to persuade them to buy their wares.

Do not immediately dismiss the efficient market hypothesis just because some of these ideas seem to run counter to it. Concepts like technical analysis have shown promise as useful trading tools, and there is evidence to support this. 

They are predicated on the idea that most investors miss out on opportunities because of the way people act in predictable ways. Therefore, there is no hope of making a profit from them yet.

Resources for Behavioral Finance

There have been a lot of excellent books and articles released recently if you’d like to learn more about behavioral finance. Because of how intricate the subject is, it is hard to list all the theories and concepts here. 

Although the area was founded in part by the writings of Adam Smith and Jeremy Bentham, these earlier efforts do not benefit investors or consumers as much as more current studies.

The materials listed below will assist you in learning more about the psychology of financial choices and how you might be able to take advantage of them when investing.

  • The focus of this blog is on behavioral finance. It aims to cover all the bases in the field of behavioral finance and succeeds admirably in doing so.
  • Bravery in the Face of False Faith. Individual investor trading tactics are discussed in depth in excellent work by Brad Barber.
  • Title; Disposition Effect in Securities Trading. The focus of this study, which is grounded in empirical research on the trading of securities, is on the propensity of investors to cling to underperforming assets while selling outperforming ones.
  • Impact of Attitude and Continual Development. This paper shows how investors typically stick with successful investments while selling off unsuccessful ones. The practice causes security to keep going in the same way.

Bottom Line

Behavior in financial markets has been studied by experts for quite some time. The data has provided us with new information that can alter our market strategies and our comprehension of consumers. Learning about consumer and investor psychology can help you spot opportunities and avoid common pitfalls.

EMH believers could have their doubts about some behavioral finance solutions. At the absolute least, though, you can apply these guidelines to identify your own mistakes and make the necessary adjustments. 

Academic and research articles can provide light on the common blunders made by both investors and consumers. It’s possible that your own mistakes will come as a complete shock to you.

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