Behavioral Finance

This article focuses on behavioral finance. It provides an overview of the history of behavioral finance. The relationship and debate between behavioral finance and neoclassical economic theory is addressed. The topics of investor bias, efficient markets, rational investors, risk attitudes, mental accounting, and investor overconfidence are explored. The issues associated with using behavioral finance to identify investor bias are discussed.

Keywords Asset Allocation; Behavioral Finance; Bias; Cognitive Science; Dividends; Efficient Market Hypothesis; Efficient Markets; Equity Premium Puzzle; Heuristics; Investor Bias; Mental Accounting; Neoclassical Economic Theory; Neoclassical Economics; Neuro-economics; Portfolio; Prospect Theory; Psychology; Rational Investors; Risk Attitudes

Finance > Behavioral Finance

Overview

Behavioral finance, also referred to as behavioral economics, combines economics and psychology to analyze how and why investors make their financial decisions. The field of behavioral finance, which has much in common with the field of cognitive psychology, offers a theoretical explanation for the sometimes irrational or emotional choices and actions of investors (Salsbury, 2004). Despite the supposition of neoclassical economics that the market is efficient and that investors are rational, investing behavior and market behavior can be wildly irrational and inconsistent. As a result of the psychology of individual investors, stocks may be mispriced and markets may be inefficient. Behavioral economics offers an explanation for economic irrationality and economic anomalies in the market as well as a strategy for capitalizing on the unique psychology and decision-making processes of individual investors. Behavioral finance, which originated in the 1970s, gained prominence and legitimacy in 2002 when psychologist Daniel Kahneman won the Nobel Prize in economics for his work in the field of behavioral economics.

Behavioral economics incorporates data and theories about investors' cognitive ability, social interaction, moral motivation, and emotional responses into economic modeling to better understand economic outcomes. Behavioral finance recognizes that individuals, including professional investors, use heuristics to make investment decisions. Heuristics, which refer to the use of experience and practical efforts to answer questions or to improve performance, are a form of selective interpretation of information. The use of heuristics, by definition, leads to incomplete information in the decision-making process (Fromlet, 2001). Behavioral finance finds that the following variables affect economic decision-making: Biases, self-control, mental accounting, savings, fairness, altruism, public good, learning, incentives, memory, attention and categorization.

Behavioral finance is an academic field and a portfolio management approach (Stewart, 2006). Financial analysts use behavioral finance to augment or supplement classical and neoclassical financial theory and approaches. The psychological factors that have long been excluded from conventional financial analysis do affect market outcomes (Fromlet, 2001). While behavioral-finance guided investing, also referred to as behavioral investing, has not eclipsed traditional modern portfolio theory, behavioral investing has established itself as a legitimate investment technique or strategy. In particular, behavioral-finance guided investing has grown in favor following the drop in technology stocks in 2000. Behavioral investors use their understanding of human psychology to find underpriced or overpriced stocks to purchase or sell. Mispriced securities have the potential to be lucrative for savvy investors (Singh, 2005).

Ultimately, behavioral finance argues that financial decision-making is influenced by individual and market psychology. Behavioral finance addresses the following issues and questions (Taffler, 2002):

• What causes stock market bubbles?
• Why is the stock market so volatile?
• Why are under and overvalued stocks difficult to identify?
• Why do stock prices appear to under react to bad news?
• Why do most boards of directors often believe their companies are undervalued by the stock market?

The field of behavioral finance characterizes investors in the following ways: Investors are often biased in their economic decision-making; investors are known to be overly-optimistic of investment decisions; investors are known to overestimate the chances of their success; and investors are known to overestimate their financial knowledge (Litner, 1998). Behavioral finance operates to create theoretical insight about investor behavior and create a system for more accurate predictions of investors' behavior.

The following sections provide an overview of the history of behavioral finance. This overview will serve as a foundation for later discussion of behavioral finance and the challenge to neoclassical economic theory. The issues associated with using behavioral finance to identify investor bias are addressed.

The History of Behavioral Finance

The academic field of behavioral finance began in 1979 when psychologists Daniel Kahneman and Amos Tversky introduced prospect theory. Prospect theory introduced a rubric for understanding how the framing of risk influences economic decision-making. Amos Tversky and Daniel Kahneman developed the field of behavioral finance through their work on the psychology of risk. Their work, and behavioral economics in general, challenges the basic assumptions of rationality inherent in the classical economic model of decision-making. Tversky and Kahneman studied three main areas: Risk attitudes, mental accounting, and overconfidence (Litner, 1998).

• Risk attitudes: While classical economic theory argues that investors are averse to risk, behavioral finance holds that investors exhibit inconsistent and often conflicting attitudes toward and about financial risk. Tversky and Kahneman found that investors have an individualized reference point for risk and will be most sensitive to risk when that reference point is reached.
• Mental accounting: While classical economic theory argues that money is fungible and interchangeable, behavioral finance holds that money is not completely fungible for most people. Tversky & Kahneman developed the idea of individualized mental accounts to explain why money is not wholly fungible for most people. Mental accounts, a wholly intangible form of accounting, contain financial resources that for personal and often irrational reasons are not easily transferred.
• Overconfidence: While classical economic theory argues that investors are rational decision makers who use the financial information that is available to them, behavioral finance holds that investors are prone to overconfidence and biased decisions. Tversky & Kahneman found that investors were often overly optimistic about investment decisions, overestimated the chances of financial success, and overestimated their financial knowledge.

In 2002, Daniel Kahneman received the Nobel Prize in economics. Richard Thaler was another important early contributor to the field of behavioral finance. Richard Thaler, in the 1980s, extended the scope of behavioral finance by making stronger connections between psychological and economics principles (Lambert, 2006). The field of behavioral finance has grown over the last three decades in large part as a result of the support that the field received from universities and research institutions.

The Russell Sage Foundation

One of the largest non-profit supporters of the behavioral finance, or behavioral economics, field is the Russell Sage Foundation. The Russell Sage Foundation provides academics and finance professionals interested in the behavioral finance field with significant research and development support. The Russell Sage Foundation began its Behavioral Economics Program in 1986 with the stated goal of “strengthening the accuracy and empirical reach of economic theory by incorporating information from related social science disciplines such as psychology and sociology.” The Russell Sage Foundation's Behavioral Economics Program established itself at the intersection between economics and cognitive psychology and dedicated the program's resources to understanding how the real-world economic decisions of investors often contradict the rational standards in economic theory. The Behavioral Economics Program promotes two major activities in the field of behavioral economics: The Behavioral Economics Roundtable, a forum for discussing new ideas, and a series of National Bureau of Economic Research (NBER) workshops(“Behavioral economics,” 2007).

Priorities of the Russell Sage Foundation's Behavioral Economics Program have included improving the effectiveness of social programs by establishing connections between behavioral economists and non-profit organizations and understanding consumer decision making regarding their own finances in order to help shape effective and appropriate regulation to promote consumer welfare. Examples of proposed projects include the following: “Programs to increase the use of checking accounts by the poor; programs encouraging taxpayers to save a portion of their federal tax rebates; pre-release programs to decrease recidivism among ex-prisoners; programs to improve portfolio decisions in retirement pension accounts; and programs to increase participation in the Medicare prescription drug benefit” (Russell Sage Foundation—Behavioral Economics, 2007, 2013).

Society for the Advancement of Behavioral Economics

In addition to the efforts of the Russell Sage Foundation to further the field of behavioral economics, the Society for the Advancement of Behavioral Economics (SABE), established in 1982, is an network of scholars committed to intensive economic analysis and interested in learning how other disciplines, such as psychology, sociology, anthropology, history, political science, and biology, promote the understanding of economic behavior. The Society for the Advancement of Behavioral Economics has a stated objective to facilitate communication between economists and scholars from related disciplines. The Society for the Advancement of Behavioral Economics serves as a forum for interdisciplinary research, such as behavioral financing, which may not have been accepted or recognized in traditional economics fields of inquiry (www.sabeonline.org/About.html).

Applications

Behavioral Finance & the Challenge to Neoclassical Economic Theory

The behavioral finance field challenges the predominant neoclassical economic theory of twentieth century. Economic theory of the twentieth century, characterized by the neoclassical economics and the modern portfolio theory, argues that investors behave in a rational and unbiased manner. Neoclassical economic theory focuses on productivity growth, supply and demand, rational investors, and efficient markets. The field of neoclassical economics emphasizes the belief that the market system will ensure a fair allocation of resources and income distribution. In addition, the market is believed to regulate demand and supply, allocation of production, and the optimization of social organization (Brinkman, 2001). Modern portfolio theory and the efficient market hypothesis (EMH) are tools for analyzing and understanding how securities are valued in the marketplace. Neoclassical economic theory holds that investors are rational, predictable, and unbiased agents and that the market is an efficient system. Modern portfolio theory argues that risk-averse investors construct their portfolios to optimize the expected return on a known and accepted level of market risk. The optimal portfolio will include security valuation, asset allocation, portfolio optimization, and performance measurement. The efficient market hypothesis argues that the market is efficient because stock prices reflect everything that investors know about stocks at any given moment (Singh, 2005).

Traditional economic theories, such as modern portfolio theory and the efficient market hypothesis, do not explain investor bias and anomalies in the marketplace. For example, there are at least five major areas where neoclassical economic theory does not explain the behavior of real investors and market outcomes. These five areas, including volume, volatility, dividends, equity premium puzzle, and predictability will be described below (Thaler, 1999):

• Volume: The volume of trade in asset markets is consistently higher than neoclassical economic theory assumes. If investors and traders were rational, as neoclassical economics supposed, than the investors and traders would hold onto investments over the long term rather than buy and sell with frequency. In practice, investors and traders have liquidity and balancing needs and, as a result, trading volume tends to be high.
• Volatility: The volatility of asset markets is consistently higher than neoclassical economic theory assumes. Neoclassical economic theory argues that prices will change only when news arrives. In practice, stock and bond prices are much more volatile than believed possible in a rational and efficient market.
• Dividends: Dividends, which refer to payments made by a corporation to its stock holders, have a stronger effect on the stock market than neoclassical economic theory assumes. Neoclassical economic theory cannot explain why stock prices increase when dividends are increased or why companies pay cash dividends.
• Equity premium puzzle: The equity premium puzzle, which refers to the observations that returns on individual stocks over the past century are higher than returns on government bonds, cannot be explained by neoclassical economic theory. The equity premium differential between government and non-government stocks and bonds is large and cannot be explained as a product of reward for greater risk.
• Predictability: The observed predictability of asset markets cannot be explained by neoclassical economic theory. In a rational and efficient market, future returns cannot be predicted on the basis of known information. In practice, there are predictable patterns in price-to-earnings ratios, company announcements of earnings, dividend changes, share repurchases, and seasoned equity offerings.

The field of behavioral finance developed in the 1970s to account for the unpredictability and seeming irrationality that economists observed in investor behavior that went unexplained in neoclassical economic theory. Behavioral finance offers tools to understand how investors interpret and act on information to make informed economic investment decisions. Neoclassical economics does not explain individual difference and anomalies. In the late 1970s, when psychologists Amos Tversky and Daniel Kahneman introduced behavioral finance, and prospect theory, as a subset of cognitive science, they were engaging and expanding the range of possible economic theory and explanations. Since the late 1970s, academics and investment professionals have been studying, both for intellectual curiosity and profit motive, how emotion, cognitive biases, and psychology of investors affects economic decisions.

Despite the refusal of neoclassical economic theory to engage the psychology of investors and markets, behavioral finance theory asserts that cognitive biases have significant affects on financial decisions. The cognitive biases that affect investor decision making, and ultimately market outcome, include the following: Anchoring, availability bias, confirmation bias, disposition effect, framing and reference dependence, illusion of control, optimism bias, overconfidence bias, overreaction, representativeness, and underreaction.

• Anchoring: The tendency to anchor expectations based on reference points that may not have any relevance to the value that is being projected.
• Availability bias: The propensity to form judgments about the probability of an event based primarily on the availability of information that favors a certain outcome.
• Confirmation bias: The seeking of information that supports an investor's belief while disregarding evidence that may be inconsistent or contradictory.
• Disposition effect: The tendency to hold losing securities too long and to sell winners too quickly because of an aversion to loss.
• Framing and reference dependence: The tendency to take into account irrelevant information when determining return expectations for an asset.
• Illusion of control: Individuals' tendency to overestimate the control they have over outcomes.
• Optimism bias: The tendency of people to believe that they are better than average and that misfortune are more likely to befall people other than themselves.
• Overconfidence bias: The tendency to be overconfident in the ability to predict the behavior of the markets, particularly as it relates to the selection of winning stocks.
• Overreaction: Seeing patterns in random events, such as projecting current trends into the future forever.
• Representativeness: The tendency to find similarities among prospects whose resemblances are only superficial, thereby taking the sample to be representative of the whole population.
• Underreaction: A reluctance to adjust one's expectations to new information.

Investment companies increasingly form behavioral finance teams to evaluate qualitative factors and issues affecting the market and investment decisions. Behavioral finance funds have become common and successful investment vehicles. Investment professionals use the perspective and tools of behavioral finance to study the anomalies in the marketplace and exploit the anomalies to their advantage. The principles of behavioral finance can be used in any asset class including equities, fixed income, convertible securities and real estate investment trusts. Behavioral finance connects investor decision-making and market movements. Behavioral finance investing can be applied across investing styles, industry sectors, and stock domains (Stewart, 2006). Despite the legitimacy and prominence of behavioral finance in academic and corporate sectors, the debate between traditional finance and behavioral finance remains strong (Shiller, 2006).

Issues

Using Behavioral Finance to Identify Investor Bias

Financial advisers working to incorporate behavioral finance into their practices face numerous challenges. There is currently no accepted finance industry approved methodology for identifying an individual investor's psychological biases. In addition, even once an investor's behavioral biases have been identified, financial advisers may lack the experience needed to incorporate these biases during the process of determining asset allocation. Most importantly, financial advisers will be challenged by the task of deciding how much individualized behavioral finance research is appropriate for each client. Financial advisers must decide whether to attempt to change their clients' biased behavior or adapt to it. Pompian and Longo (2005) suggest the use of two behavioral finance guidelines or principles:

• First, financial advisers should adapt to biases at high wealth levels and attempt to modify behavior at lower wealth levels.
• Second, financial advisers should adapt to emotional biases and moderate cognitive biases.

Guidelines for incorporating biases in asset allocation decisions will help financial advisers accomplish the following objectives: Moderate the way clients naturally behave to counteract the affects of “behavioral biases so that they can fit a pre-determined asset allocation; adapt to clients' biases, so that clients can comfortably abide by their asset allocation decisions; and establish the quantitative parameters” (p. 2) that will allow the financial adviser to successfully moderate or adapt the client biases. Ultimately, the application of behavioral finance to individual clients is a sensitive process that would benefit from the adoption of finance industry guidelines and direction (Pompian & Longo, 2005).

Conclusion

Neoclassical economic theory considers investors and markets to be rational and efficient entities. In practice, investors may be emotional, biased, and overconfident. The market reacts and responds to the individual biases and behaviors of investors and market anomalies occur. The field of behavioral finance, also referred to as behavioral economics, was established in the 1970s to explain how and why the psychology of investors effect financial decision making and market behavior. Behavioral economics combines economics and psychology to analyze how and why investors make their financial decisions. Behavioral finance, which has much in common with the field of cognitive psychology, offers a theoretical explanation for investors' sometimes seemingly irrational or emotional choices and actions.

The field of behavioral finance will likely continue to grow in strength and scope; it will likely remain a strong investment tool or approach. Due to the volatility of markets, behavioral finance guided investing is considered to be one of many key investment strategies in a diversified portfolio (Stewart, 2006). The field of behavioral finance is expanding to include the field of neuroeconomics. Neuroeconomics is an area of study that combines neurology, economics, and psychology to analyze how people make economic choices. Neuroeconomics expands behavioral finance by adding in the variable of the nervous system as a factor in economic decision-making. In the final analysis, the growth of the behavioral finance field allows for greater understanding of the ways in which psychological variables affect investment outcomes and market behavior (Shiller, 2006).

Terms & Concepts

Asset Allocation: The act of apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon.

Behavioral Finance: A field of study that combines economics and psychology to analyze how and why investors make their financial decisions.

Bias: A personal preference or prejudice.

Cognitive Science: The interdisciplinary study of perception, memory, judgment and reasoning.

Dividends: Payments made by a corporation to its stock.

Efficient Market Hypothesis: A theoretical framework for understanding how securities are valued in the marketplace.

Equity Premium Puzzle: The observation that returns on individual stocks over the past century are higher than returns on government bonds.

Heuristics: A performance enhancing technique that relies on experience and practical efforts.

Neoclassical Economic Theory: A school of economic thought, which began in the nineteenth century in response to perceived weaknesses in classical economics, that focuses on productivity growth, supply and demand, rational investors, and efficient markets.

Neuro-economics: An area of study that combines neurology, economics, and psychology to analyze how people make economic choices.

Portfolio: A collection of investments held by an individual or group.

Prospect Theory: A rubric for understanding how the framing of risk influences economic decision-making.

Psychology: The science that studies mental processes and behavior.

Bibliography

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Fromlet, H. (2001). Behavioral finance-theory and practical application. Business Economics, 36, 63. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5057707&site=ehost-live

Herciu, M., & Ogrean, C. (2014). Corporate Governance and Behavioral Finance: From Managerial Biases to Irrational Investors. Studies In Business & Economics, 9, 66-72. Retrieved November 5, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=98353325

Hyoyoun, P., & Wook, S. (2013). Behavioral finance: A survey of the literature and recent development. Seoul Journal of Business, 19, 3-42. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90591091&site=ehost-live

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Matsumoto, A. S., Fernandes, J. B., de M. Cunha, G., & de Abreu Araújo, E. (2013). Behavioral finance: A psychophysiological study of decision making. Journal of International Business & Economics, 13, 189-194. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91834253&site=ehost-live

Peteros, R., & Maleyeff, J. (2013). Application of behavioural finance concepts to investment decision-making: Suggestions for improving investment education courses. International Journal of Management, 30(1 Part 2), 249-261. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85634555&site=ehost-live

Pompian, M., & Longo, J. (2005). Incorporating behavioral finance into your practice. Journal of Financial Planning, 18, 58-63. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=16401771&site=ehost-live

Riepe, M. W. (2013). Musings on Behavioral Finance. Journal Of Financial Planning, 26, 34-35. Retrieved November 5, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87563903

Shiller, R. (2006). Tools for financial innovation: Neoclassical versus behavioral finance. Financial Review, 41, 1-8. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19398002&site=ehost-live

Salsbury, G. (2004). Psychoanalysis has met investing. What does it mean for advisors? National Underwriter: Life & Health, 108, 20-22.

Stewart, P. (2006). Behavioral finance-not to be ignored. Trusts & Estates, 145, 46-51.

Taffler, R. (2002). What can we learn from behavioral finance? Credit Control, 23, 14-17.

Thaler, R. (1999). The end of behavioral finance. Financial Analysts Journal, 55, 12-17. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=2762863&site=ehost-live

Suggested Reading

Brav, A., Heaton, J., & Rosenberg, A. (2004). The rational-behavioral debate in financial economics. Journal of Economic Methodology, 11, 393-409. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15491212&site=ehost-live

Nevins, D. (2004). Goals-based investing: Integrated traditional and behavioral finance. Journal of Wealth Management, 6, 8-23. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12415661&site=ehost-live

Statman, M. (1999). Behavioral finance: Past battles and future engagements. Financial Analysts Journal, 55, 18-27. Retrieved September 3, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=2762864&site=ehost-live

Wasik, J. F. (2014). Bet Against Human Nature. Forbes, 193, 120. Retrieved November 5, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=96734055