Behavioral finance is still a relatively new field. Nonetheless,
or maybe even due to it being new, behavioral finance is gaining steam and is
becoming more and more popular among investors and academics.
Behavioral finance opens the door for further study and
gives the chance for strategist to develop more investing strategy.
Let’s take a quick ride through the history and definition
of behavioral finance.
What is Behavioral Finance?
Behavioral finance is one field of finance that puts forward
psychology-based theories. These theories, similar to other theories, attempt to
explain market anomalies taking place in the market.
According to behavioral finance, different information, as
well as the personalities of the market participants, affects their investment decision-making
processes. Therefore, these things also
affect market outcomes, hence the anomalies.
Read further: Market Sentiment: Bearish VS Bullish
Contradicting the EMH
According to the efficient market hypothesis, market prices
reflect all available information at any given time in any liquid market.
On the flip side, numerous studies and documents have shown
contradicting phenomenon against the EMH. Simply put, the efficient market
hypothesis cannot explain everything that’s happening in the market.
This is because the EMH always assumes that market participants
always act rationally, following logic for them to better maximize their wealth
and improve themselves.
What happens is that these assumptions limit the models’ capacity
to make accurate and precise predictions.
Behavioral finance tries to succeed where the EMH failed by
mixing scientific insights into cognitive reasoning and financial and economic
theory. Perhaps one of the most important aspects of behavioral finance is its
study of different human psychological biases.
Such biases are not necessarily inherently bad, but they can
affect an investor’s investing decisions. The mental shortcuts are to be blamed
when market panic and bubbles occur.
Let’s dig into what these common biases are.
Bias # 1: Worry
Worrying is a very natural human emotion, and you can very easily
observe this among many people. When you worry, you conjure up images or future
scenarios that could be very negative.
And such negativity can compel you to change your investment
resolve, thus altering your judgment about your finances. When you worry about an
investment, you increase your perceived risk in the process. Therefore, your
risk tolerance also becomes lower.
The simple fix to this bias is to match your asset allocation strategy with your risk tolerance.
Bias #2: Trend-chasing Bias
Many investors believe that history will always repeat
itself. While this can be true, it doesn’t guarantee anything—especially in the
world of investing.
Investors typically run after the past performance of an investment,
thinking that historical return can predict the future performance of the
investments. This can be worse with the fact some product or asset issuers
capitalize on the investment’s past performance to attract investors.
Keep in mind that research shows that not all investors
benefit from this because performance doesn’t persist.
Related: What is Trend Trading?
Bias #3: Self-Attribution Bias
When you have this bias, you will most likely attribute successful
results to your own action but blame bad results to external factors.
In other words, you don’t own up to bad results due to your
bad decisions, and you will gravitate towards overconfidence. The underlying
reason to this bias is the investor’s need for self-enhancement or
self-protection.
Bias #4: Familiarity Bias
This bias happens when an investor has more appetite for
familiar or well-known investments even if they see the obvious gains from
diversification.
An investor may feel anxious by the prospect of investing
for diversification between familiar securities and lesser known ones. This
bias prevents the investor to explore and invest in better performing
investments just because they are outside his or her comfort zone.
When this bias is not
checked and fixed, it can lead to suboptimal portfolios with greater risks for
losses.
Bias #5: Hindsight Bias
The hindsight bias is not uncommon among investors. This
bias makes you believe after the fact that the coming of a past event was obvious
and predictable even if, in fact, there was no possible way to predict that
event accurately.
Bias #6: Disposition Effect Bias
The disposition effect bias refers to an investor’s tendency
to tag investments as winners or losers.
As a result, having this bias makes you hold on to losing investments
or those that no longer sports any upside, just because you think it’s a
winner. You would also more likely sell well performing investments too early
to make up for the previous losses.
This can lead to your capital gains taxes becoming bigger,
and it can even reduce your returns even before deducting the taxes.
Bias #7: Regret Aversion Bias
This is also known as loss aversion, which refers to the tendency
to avoid experiences that might cause regrets, such as making choices that result
to negative outcome.
If you are bugged with this bias, you would take fewer risks
because you could avoid potential negative outcomes if you do so.
In addition, risk aversion can be the underlying reason why
some investors refuse to sell a losing investment as a way to avoid admitting
that they have made poor decisions.
Bias #7: Anchoring or Confirmation Bias
Investors also have a tendency to filter the information and
opinions they receive. In the process, it also makes it hard for them to erase
their initial opinions or perception of a certain investment.
When you have this bias, you selectively filter information
and opinions by choosing only those that support or confirm your preconceived belief.
You would also most likely refuse to see the point of someone or something new
if it contradicts your initial belief.
Conclusion: Understand Your Behavior First
Behavioral finance has provided a new way to understand the
behavior of the markets. Therefore, it offers us some insight on how we could
use the reasons underpinning market anomalies to beat the market.
The most important takeaway here is that by understanding
how these biases work and affect investors, you can also improve your
decision-making skills and perhaps remove your own biases toward investing.
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