What Is Behavioral Finance?

Behavioral finance, a subfield of 澳洲幸运5官方开奖结果体彩网:behavioral economics, proposes that psychological influences and biases affect the financial b✨ehaviors of investors and financial practitioners. Moreover, influences and biases can explain al꧟l types of market anomalies, including those in the stock market, such as severe rises or falls in stock price.

Given that behavioral finance is such an integral part of investing, the U.S. Securi🧜ties anꦺd Exchange Commission has staff specifically focused on behavioral finance.

Understanding Behavioral Finance

Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one area of finance where 澳洲幸运5官方开奖结果体彩网:psychological behaviors are often assumed to influence market outcomes and returns but there are also many different angles for observation. The purpose of the classification of behavioral finance is to help understand 澳洲幸运5官方开奖结果体彩网:why people make cerℱtain financial choices and how those choices can affect markets.

Within behavioral finance, it is assumed that ♏澳洲幸运5官方开奖结果体彩网:financial participants are not perfect꧟ly rational and self-controlled but rather psychologically influential with somewhat normal and self-controlling tendencies. Financial decision-making often relies on the investor's mental and physical health. As an investor's overall health improves or worsens, their mental state often changes. This impacts their decision-making and rationality towards all re🎀al-world problems, including those specific to finance.

One of the key aspects of behavioral finance studie🍷s is the influence of biases. Biases can occur for a variety of reasons. Biases can usually be classified into one of five key concepts. Understanding and classifying different types of behavioral finance biases can be very important when narrowing in on the study or analysis of industry or sector outcomes and results.

Behavioral Finance Concepts

Behavioral finance typically en✨compasses 🐲five main concepts:

• Mental accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes.
• 澳洲幸运5官方开奖结果体彩网:Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the 澳洲幸运5官方开奖结果体彩网:stock market as the cause behind dramatic rallies and sell-offs.
• 澳洲幸运5官方开奖结果体彩网:Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices.
• 澳洲幸运5官方开奖结果体彩网:Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities. 
• 澳洲幸运5官方开奖结果体彩网:Self-attribution: Self-attribution refers to a tendency to make choices based on overconfidence in one's own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short.

Some Biases Revealed by Behavioral Finance

Breaking down biases furt🍬her, many individual biases and tend🐼encies have been identified for behavioral finance analysis. Some of these include:

Confirmation Bias

Confirmation bias is when investors have a bias toward accepting information that confirms their already-held belief in an inv🍃estment. If information surfaces, investors accept it readily to confirm that they're correct about their investment decision—even if the information is flawed.

Experiential Bias

An experiential bias occurs when investors' memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as 澳洲幸运5官方开奖结果体彩网:recency bias or 澳洲幸运5官方开奖结果体彩网:availability bias.

For example, the financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the coming years. The experience of having gone through such a negative event increased their bias or likelihood that the event could reoccur. In reality, the economy recovered, and the market bo😼unced back in the years to follow.

Loss Aversion

澳洲幸运5官方开奖结果体彩网:Loss aversion occurs when investors place greater weight on the concern for losses than the pleasure from market gains. In other words, they're far more likely to try to assign a higher priority to avoiding losses than to making inveܫstment gains.

As a result, some investors might want a higher payout to compensate for losses. If the high payout isn't likely, they might try to avoid losses altogether, even if the investment's risk is acceptable from a rational standpoint.

Applying 澳洲幸运5官方开奖结果体彩网:loss aversion to investing, the so-called disposition effect occurs when investors sell their winners and hang onto their losers. Investors' thinking is that they want t⛄o realize gains quickly. However, when an investment is losing money, they'll hold onto it because they want to get back to even or their initial price. Investors tend to admit they are correct about an investment quickly (when there's a gain).

However, investors are reluctant to admit when they made an investment mistake (when there's a loss). The flaw in disposition bias is that the performance of the investment is often tied to the entry price for the investor. In other words, investors gauge the performance of their investment based on their individual entry price, disregarding the fundamentals or attributes of the investment that may have changed.

Familiarity Bias

The 澳洲幸运5官方开奖结果体彩网:familiarity bias is when investors 澳洲幸运5官方开奖结果体彩网:tend to invest in what they know, such as domestic companies or locally owned investments. As a resultไ, investors are not diversified across multiple sectors and types of investments, which can reduce risk. In🦩vestors tend to go with investments that they have a history or have familiarity with.

Behavioral Finance in the Stock Market

The efficient market hypothesis (EMH) says that at any given time in a highly 澳洲幸运5官方开奖结果体彩网:liquid market, stock prices are efficiently valued to reflect all the available information. However, many studies have documented long-term historical phenomena in securities markets that 澳洲幸运5官方开奖结果体彩网:contradict the efficient marke🦋t hypoth👍esis and can't be plausibly capt🦩ured in models based on perfect investor rationality.

The EMH is generally based on the belief that market participants view stock prices rationally based on all current and fut🦹ure intrinsic and external factors. When studying the stock market, behavioral finance takes the view that markets are not fully efficient. This allows for the observation of how psychological and social factors can influence the buying and selling of stocks.

The understanding and usage of behavioral finance biases can be applied to stock and other trading market movements on a daily basis. Broadly, behavioral finance theories have also been used to provide🍬 clearer explanations of substantial market anomalies like bubbles and deep recessions. While not a part of EMH, investo༺rs and portfolio managers have a vested interest in understanding behavioral finance trends. These trends can be used to help analyze market price levels and fluctuations for speculation as well as decision-making purposes. 

The Bottom Line

Behavioral finance is an area of economics that fuses with psycholog🗹y. It ascribes the often irrational behavior of individuals when faced with financial choicesꦺ to a variety of biases and heuristics. Often, individuals are unaware of the underlying biases at work that can underlie bad decision-making. A study of this area of finance is essential to anyone who wants to master the art of trading and investing.