Behavioral Finance: Investors & Psychology

• Behavioral finance helps investors understand how emotions influence financial decisions about risks and investments.
• The objective is to understand how psychology affects investors' decisions.

Definitions of Behavioral Finance

• Lintner G. (1998): Behavioral finance studies how humans interpret and act on information for informed investment decisions.
• W. Forbes (2009): Behavioral finance is a science about how psychology influences financial markets.
• Shefrin (1999): Behavioral finance deals with psychology's influence on financial practitioner behavior.

Development of Behavioral Finance

• Established in the 1980s by interdisciplinary teams, including psychologists, sociologists, economists, and engineers.
• Festinger, Recken, and Schachter (1956): Theory of cognitive dissonance.
• Tversky and Kahneman (1973, 1974): Heuristic biases like availability, representativeness, anchoring, and adjustment.
• Grinblatt and Keloharju (2001): Role of behavioral factors in determining trading behavior.
• Hubert Fromlet (2001): Importance of behavioral finance, focusing on departure from homoeconomicus.
• Coval and Shumway (2006): Effects of behavioral biases on stock prices.

Scope of Behavioral Finance

• Comprehending investor personalities to determine behavior.
• Improving investment skills by helping investors analyze methods and identify investment goals.
• Understanding corporate activities to help investors develop good personalities in dealing with them.

Objectives of Behavioral Finance

• Improves decision making.
• Provides accurate knowledge to investors unaware of possible risks.
• Identifies emotions investors manifest in dealing with risks.

Standard/Traditional Finance vs. Behavioral Finance

• Standard Finance relies on rationality in investments, without influence from emotions or expectations.
• Behavioral Finance pertains to investor and financial manager behavior in investment decisions, with behavior affecting outcomes.
• Standard Finance assumes people process data correctly, driven by logic, reasons, and judgments.
• Behavioral Finance suggests people use imperfect rules of thumb, driven by emotions and herd instincts.
• Standard Finance assumes markets are efficient and risks/returns are transparent.
• Behavioral Finance sees markets as somewhat efficient, assuming risk and return are under frame dependence.

Heuristics (Rule of Thumb)

• It's the act of drawing a conclusion without considering circumstances.
• A mental shortcut to simplify problems and avoid cognitive overload, allowing quick, reasonable conclusions.

Example No. 1

• Recognizing a potential threat and subtly avoiding it leverages a heuristic to evaluate the situation.

Example No. 2

• Using well-known investment firms as a shortcut to determining the best investments.

Heuristics and Psychology

• Herbert Simon observed investors use shortcuts for immediate job completion, instead of acting rationally.
• Amos Tversky and Daniel Kahneman developed Prospect Theory to help investors make decisions by observing potential gains or losses.

Advantages of Heuristics

• Deliver immediate results.
• Speed up investment decisions.

Disadvantages of Heuristics

• Can lead to miscalculation of investments.
• Can lead to poor choices.
• Decisions can be inaccurate.

Availability Heuristic

• It's the act of making a quick judgment based on past events.
• Predicts the possibility or probability of an event based on the capacity to recall past events.

Example No. 1

• Someone is hesitant to invest money as they know they will lose it again.

Example No. 2

• Someone wants to invest in cryptocurrencies may decide based on the historical performance of the most popular digital coins.

Anchoring and Adjustment

• It occurs when a person is dependent on the financial facts that are initially received.
• This occurs when an analyst utilizes a pricing model
• All options and choices affect and require immediate adjustments to stick with the initial information.
• It is a phenomenon when an individual bases their initial ideas and responses on one point of information and makes changes driven by that starting point.

Example

• Used car salesman can offer a very high price to start negotiations that are arguably well above the fair value.

Representativeness

• Happens when investors have a firm conviction that the past performance of a certain investment will continue.
• Under uncertainty, investors tend to believe that a history of a remarkable performance of a given firm is representative of a general performance that the firm will continue to generate in the future.

Cognitive Bias

• Systematic error in thinking that affects decisions and judgments.

Info Processing Errors

Framing Bias

• Investors in a scenario where they already have enough gains, they are more likely to defend such gains by simply adopting a risk-reduction mentality.
• They are prone to adopt a risk-taking mentality when they have lost money.
• Framing is the way in which a question is structured with regard to the issue being evaluated.

Availability Bias

• Judging the hood of an event based on how easily example come to mind, rather than considering objective probability.

Belief Perseverance Bias

• Occurs when investors and individuals are unable to modify their beliefs.
• They tend to stick to their belief and and refuse to learn new information.

Conservatism/Anchoring Bias

• Occurs when investors resist to accept change because they base their decisions on the initial impression they created.
• Human mind always resist change because it is conservative.

Overconfidence

• Occurs when investors overestimate their skills.
• This action can make anyone believe that they are already competent investors.
• A tendency to hold a false and misleading assessment of our skills, intellect, or talent.

Confirmation Bias

• Investors or individuals to search for more information to confirm that their belief is accurate.
• The tendency is that, with this bias, investors will only focus on the confirm data that supports the investment, which is something they highly esteem or consider.

Illusion of Control

• Occurs when investors believe that they have the ability to control a situation even though they cannot.
• Results in overestimating ability to control the events.

Hindsight Bias

• The inclination to predict the event before they happen and get imbibed with the feelings that people know it prior to that.
• Understanding of the situation after they happen bring around towards this bias.

Emotional Bias

Loss Aversion

• Occurs when a loss in investment is considered a loss as an unpleasant scenario.
• A pervasive phenomenon in human decision making under risk and uncertainty, according to which people are more sensitive to losses than gains.

Self-Control Bias

• Due to lack of self-discipline, investors or businessmen prefer to adopt income-generating resources.
• Frequently have the “spend-today" mentality.
• Causes people to fail to act in pursuit of their long-term overarching goals because of a lack of self-discipline in the short term.

Endowment Bias

• Occurs when people exhibit or manifest their sense of ownership in something even though it is time to let go.
• Willing to pay a high price just only to retain it.
• Buyers often have different reference prices in mind for an item, which leads gaps in their willingness to pay or accept a given price.

Status Quo Bias

• Occurs when individuals tends to retain their financial situation by simply not doing anything or by maintaining their choice or decision.
• They oppose actions that can possibly alter a certain situation.
• Describes our preference for the current state of affairs; resulting in resistance to change."

Prospect Theory

• Pertains to how people make decisions when a theory is presented with uncertainty.
• Investors choose to keep their capital to avoid loss rather than to invest.
• It has done more to bring psychology into the heart of economic analysis than any other approach.

Two phases of Prospect Theory

Editing Phase

• This is the initial stage where choices are framed and organized.
• People simplify and structure their options based on how information is presented.
• Decisions in this phase are influenced by psychological factors, such as reference points and perceived gains/losses.

Evaluation Phase

• After framing the choices, individuals assess the possible outcomes.
• They weigh risks and potential rewards based on past experiences and statistical analysis.
• People tend to be loss-averse, meaning they give more weight to potential losses than to equivalent gains.