What Is Behavioral Finance?

Behavioral finance is a branch of behavioral economics that suggests that psychological factors and biases play a role in the financial behaviors of investors and financial professionals. These influences and biases may be responsible for unusual market trends, particularly in the stock market. Given the importance of behavioral finance in investing, the Securities and Exchange Commission has dedicated staff to this area.

Understanding behavioral finance

Behavioral finance can be examined from various angles, including stock market returns where psychological factors are believed to have an impact on market performance and returns. The goal of studying behavioral finance is to understand why people make certain financial decisions and how those choices can affect markets.

It is generally accepted that financial participants are not perfectly rational and self-controlled, but rather have psychological influences and tend to be normally self-controlled. Financial decision making can be influenced by an investor's mental and physical health, as changes in overall health can affect an investor's mental state and thus their rationality and decision making in financial matters.

The study of behavioral finance often focuses on the influence of biases, which can be caused by various factors. These biases can typically be grouped into five main categories. Understanding and classifying different types of behavioral finance biases can be crucial when analyzing industry or sector outcomes and results.

Behavioral finance concepts

Behavioral finance typically encompasses five main concepts:

• Mental accounting: The tendency to allocate money for specific purposes.
• Herd behavior: The tendency to mimic the financial behaviors of the majority of the herd, often seen in stock market rallies and sell-offs.
• Emotional gap: Decision making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement.
• Anchoring: Attaching a spending level to a certain reference, such as spending consistently based on a budget or rationalizing spending based on satisfaction utilities.
• Self-attribution: The tendency to make choices based on overconfidence in one's own knowledge or skill, often stemming from an intrinsic knack in a particular area. This can involve ranking one's knowledge higher than others, even when it falls short objectively.

Some biases revealed by behavioral finance

Behavioral finance analysis often involves examining specific biases and tendencies. Some examples include:

• Confirmation bias: A tendency to accept information that confirms one's already-held belief in an investment, even if the information is flawed.
• Experiential bias: A bias or belief that recent events are more likely to reoccur, also known as recency bias or availability bias.
• Loss aversion: A greater weighting on the concern for losses compared to the pleasure from market gains, leading to a higher priority on avoiding losses rather than making investment gains.
• Disposition effect: The tendency to sell investments that have gained value and hold onto those that have lost value, driven by the desire to realize gains quickly and avoid admitting mistakes.
• Familiarity bias: A preference for investing in what one knows, such as domestic companies or locally owned investments, leading to a lack of diversification across sectors and types of investments.

Behavioral finance in the stock market

According to the efficient market hypothesis (EMH), stock prices in a highly liquid market are efficiently valued to reflect all available information at any given time. However, there is evidence of historical phenomena in securities markets that contradict the EMH and cannot be explained by models based on perfect investor rationality.

The EMH is based on the idea that market participants rationally consider all current and future intrinsic and external factors when determining stock prices. In contrast, behavioral finance assumes that markets are not fully efficient, and that psychological and social factors can affect stock buying and selling.

Behavioral finance biases can be applied to stock market movements on a daily basis and have also been used to explain significant market anomalies such as bubbles and recessions. However, not part of the EMH, investors and portfolio managers may find it beneficial to understand behavioral finance trends to analyze market price levels and fluctuations for speculation and decision-making purposes.