How can behavioral finance help you understand investor preferences?

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Behavioral finance is a field that studies how psychological factors influence the decisions and actions of investors. It can help you understand why investors sometimes deviate from rationality, efficiency, and diversification, and how they cope with uncertainty, risk, and emotions. In this article, you will learn about some of the key concepts and biases of behavioral finance, and how they can affect your preferences and performance as an investor.

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Michael Gilmore

Founder of The Money Awareness & Inclusion Awards | Championing Financial Literacy & Inclusion | Research Director at…
Clint Engler

CEO/Principal: CERAC Inc. FL USA..... ?? ????????Consortium…

1 Prospect theory

One of the most influential concepts in behavioral finance is prospect theory, developed by Daniel Kahneman and Amos Tversky. Prospect theory suggests that investors evaluate outcomes based on changes from a reference point, rather than absolute values. They also exhibit loss aversion, meaning they dislike losses more than they like gains of the same magnitude. This can lead to irrational behaviors, such as holding on to losing stocks too long, or selling winning stocks too soon.

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Clint Engler

CEO/Principal: CERAC Inc. FL USA..... ?? ????????Consortium for Empowered Research, Analysis & Communication
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Tailor your investment recommendations to better align with individual risk tolerance and decision-making styles. Craft clearer and more persuasive communication that resonates with investors' emotional triggers. Develop products and services that address common behavioral pitfalls and promote sound financial choices. Ultimately, behavioral finance empowers you to bridge the gap between logic and emotion, leading to stronger relationships and more effective investment strategies for both you and your clients.

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2 Framing effect

Another important concept in behavioral finance is the framing effect, which refers to how the presentation of information can influence the perception and choice of investors. For example, investors may react differently to the same information if it is framed as a gain or a loss, or as a percentage or a dollar amount. Framing can also affect the risk and return trade-off, as investors may prefer a certain outcome over a risky one, or vice versa, depending on how the options are framed.

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3 Heuristics and biases

Behavioral finance also identifies several heuristics and biases that investors use to simplify and process information, but that can also lead to errors and misjudgments. For instance, overconfidence can cause investors to overestimate their own abilities and knowledge, while confirmation bias may lead them to seek and interpret information that confirms their existing beliefs. Additionally, anchoring may cause investors to rely too much on the first piece of information received, availability bias can lead them to judge the likelihood of events based on how easily they come to mind rather than their actual probability, and herding can cause investors to follow the actions and opinions of others instead of their own analysis and judgment. As a result, these heuristics and biases can have a significant impact on how investors form expectations, assess risks, select portfolios, and react to market movements.

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Jamie Lee

Team Lead, Digital Product Management (Regional), Consumer Banking
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Loss aversion is one of the commonly cited cognitive bias that shapes investors’ decisions. It suggests that investors hurt more from losing, than celebrate from winning. This has a broader impact on risk-taking: for e.g., investors may stick with low-risk fixed deposits even though they are unlikely to beat inflation, than invest in stocks that have a higher risk but that have historically delivered over the long term. Sometimes, if you can’t beat them, join them. Specifically in this example, try illustrating how inflation erodes pricing power to bring to life the true investment “loss” from such risk aversion.

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4 Emotional finance

Behavioral finance recognizes the role of emotions in influencing investor behavior. Fear, greed, regret, and pride are all common emotions that investors experience. Fear can cause investors to avoid risks or sell prematurely, while greed may lead to taking excessive risks or holding too long. Regret can cause investors to feel dissatisfied or blame themselves or others, while pride can lead to feeling satisfied or becoming overconfident. These emotions can affect how investors cope with uncertainty, volatility, and feedback. By understanding behavioral finance concepts and biases, as well as the psychological factors that shape investor preferences, you can improve your own decision-making and performance as an investor. You can learn to recognize and correct the common pitfalls of behavioral finance, and use its insights to your advantage.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Michael Gilmore

Founder of The Money Awareness & Inclusion Awards | Championing Financial Literacy & Inclusion | Research Director at Albizia Capital
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Very few of us are taught about money in any way, and as a result, we tend to connect it to all kinds of emotions that we shouldn't use. The fact that so many of these biases are also found among seasoned investors shows how little chance anyone without any experience or education faces. The prevalence of sayings like "don't invest money you can't afford to lose" and "the markets are a casino" show how common cultural knowledge run counter to reality in many many ways. Early education about money, and detailed high school instruction on practicalities will help reduce these factors, mainly by encouraging practice. The more we invest, the more we see our own biases, and the more we can really learn.

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How can behavioral finance help you understand investor preferences?

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1 Prospect theory

2 Framing effect

3 Heuristics and biases

4 Emotional finance

5 Here’s what else to consider

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