Behavioral Finance

Key concepts of behavioral finance

Pioneers in the field of behavioral finance have identified the following factors as some of the key factors that contribute to irrational and potentially detrimental financial decision making.

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Anchoring: Investors have a tendency to attach or anchor their thoughts to a reference point-even though it may have no logical relevance to the decision at hand e.g. investors are often attracted to buy shares whose price has fallen considerably because they compare the current price to the previous high (but now irrelevant) price.

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Gambler's fallacy: Investors have a tendency to believe that the probability of a future outcome changes because of the occurrence of various past outcomes e.g. If the value of a share has risen for seven consecutive days, some investors might sell the shares, believing that the share price is more likely to fall on the next day. This is not necessarily the case.

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Herd behavior: This is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity-most people are very sociable and have a natural desire to be accepted by a group. The second is the common rationale that it's unlikely that such a large group could be wrong. This is especially prevalent in situations in which an individual has very little experience.

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Over-reaction and availability bias: According to the EMH, new Information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly. Reality, however, tends to contradict this theory. Often participants in the stock market predictably over-react to new information, creating a larger-than-appropriate effect on a security's price.

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Confirmation bias: It can be difficult to encounter something or someone without having a preconceived opinion. This first impression can be hard to shake because people also tend to selectively fitter and pay more attention to information that supports their opinions, while ignoring or rationalizing the rest. This type of selective thinking is often referred to as the confirmation bias.

In investing, the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. As a result, this bias can often result in faulty decision making because one-sided information tends to skew an investor's frame of reference, leaving them with an incomplete picture of the situation.

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Hindsight bias and overconfidence: Hindsight bias occurs in situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted. Many events seem obvious in hindsight. For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s were very obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn't have escalated and eventually burst. For investors and other participants in the financial world, the hindsight bias is a cause for one of the most potentially dangerous mind-sets that an investor or trader can have: overconfidence. In this case, overconfidence refers to investors or traders unfounded belief that they possess superior stock-picking abilities.

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Source: Kaplan