Celestin Pepin is an associate at Invescap SA in Geneva, Switzerland, where his job involves analyzing financial data. He is a graduate of the University of St. Gallen and takes a particular interest in behavioral finance. This article will take a closer look at behavioral finance and how an individual’s biases can cloud their investment decisions and outcomes.
Behavioral finance looks at how psychology influences the behavior of investors and the subsequent impact on markets. It centers around the principle that investors do not always act rationally, exploring how they are swayed by their own biases and the limitations on their self-control.
Behavioral finance differs from traditional financial theory in that the latter is built on the belief that both investors and the market are perfectly rational. Traditional finance suggests that investors have perfect self-control, care about utilitarian characteristics, and do not fall foul of cognitive or information processing errors. Behavioral finance theory, on the other hand, suggests that investors are “normal” rather than “rational”, with limits on their self-control. Behavioral finance is rooted in the belief that investors are swayed by their own biases and prone to cognitive errors that can culminate in poor decisions and less-than-optimal investment outcomes.
Decision-making biases and errors explored in behavioral finance include:
- Self-deception, where the investor believes they know more than they actually do, leaving them vulnerable to missing the information required to make an informed decision.
- Heuristic simplification, leading to information-processing errors.
- Emotion, a critical aspect in investment decisions, with the investor’s choices led by their emotional state rather than data and facts. Behavioral finance suggests that the investor’s mood could impact their ability to think rationally and make sound investment decisions.
- Social influence, leaving the investor prone to being swayed by others rather than making fact-based choices.
Behavioral finance seeks to understand the impact of personal biases on investors. These biases include overconfidence, the illusion of control, hindsight bias, self-attribution bias, confirmation bias, and the narrative fallacy. In addition, representative bias, anchoring bias, framing bias, loss aversion bias, and herding mentality can all cloud the investor’s judgement.
Today, behavioral finance is regarded as an integral part of investment, so much so that the US Securities and Exchange Commission has a department solely focused upon it. One area where psychological behaviors can have a significant impact on market outcomes is the stock market, leaving retail investors vulnerable to making impulsive, emotion-driven investment decisions that could cost them dearly. From purchasing at the top and selling at the bottom to making poor choices due to “fear of missing out,” behavioral finance experts point to a range of irrational patterns traders can fall into.
Gaining a basic understanding of how and when investors deviate from rational expectations paves the way for better decisions in financial matters. For example, the disposition effect occurs where an investor holds onto a losing investment longer than is rational or sells their winners too early. Uniting the world of economics and psychology, behavioral finance explores irrational behavior of investors when faced with financial choices and how their decisions can be impacted by biases and heuristics. Usually, the individual is unaware of the underlying biases that shape their thought processes and often culminate in subpar decision-making.
Even when armed with all the facts people can make mistakes, as it can be difficult to remove emotions, personal perspectives, and assumptions. Emotional investing leaves investors vulnerable to ill-advised behavior such as chasing losses and insufficient diversification. As human behavior is inherently unpredictable, market inefficiencies and volatility is inevitable. Behavioral finance peels back the layers, exploring how investing behavior can translate to poor performance and outcomes.