Behavioral Finance

How processing errors and biases impact investors

What is Behavioral Finance?

Behavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners and ultimately, the subsequent effect on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.

 

Behavioral Finance Investors

 

Traditional Financial Theory

In order to understand behavioral finance, let’s contrast it first with traditional financial theory.

Traditional finance is predicated on the belief that:

  • Both the market and investors are perfectly rational
  • Investors truly care about utilitarian characteristics
  • Investors have perfect self-control
  • Investors are not confused by cognitive errors or information processing errors

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Behavioral Finance Theory

Now let’s take traditional financial theory with behavioral finance.

Traits of behavioral finance are:

  • Investors are treated as “normal” not “rational”
  • Investors actually have limits to their self-control
  • Investors are influenced by their own biases
  • Investors make cognitive errors that can lead to wrong decisions

 

Decision-Making Errors and Biases

Let’s explore some of the buckets or building blocks that make up behavioral finance.

As we’ve already talked about, behavioral finance is looking at investors as “normal” but also as being subject to decision-making biases and errors. We can break down the decision-making biases and errors into at least four buckets.

 

behavioral finance - factors that impact investors

 

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#1 Self-Deception

The concept of self-deception is a limit to the way we learn. By tricking ourselves into thinking we know more than we do, we are closed off to information that we need to make an informed decision.

 

#2 Heuristic Simplification

We can also scope out a bucket that is often referred to as heuristic simplification.  In other words, it is heuristic simplification is information-processing errors.

 

#3 Emotion

We can also scope out a bucket that’s related to emotion, but we’re not going to dwell on this bucket in this introductory session. However, I’m sure we all have experiences where our decisions have been influenced by whether we’re angry, sad, happy, and so on. That’s really what we are getting at – how mood affects our decision making.

 

#4 Social Influence

In this final bucket, we will talk about the social bucket. What we mean by the social bucket is how our decision making is influenced by others.

 

Top 10 Biases in Behavioral Finance

One of the main breakthroughs in behavioral finance is an understanding of the impact of personal biases on investors. Below is a list of the most common biases investors are subject to, whether they know it or not.

Common biases include:

  1. Overconfidence and illusion of control
  2. Self Attribution Bias
  3. Hindsight Bias
  4. Confirmation Bias
  5. The Narrative Fallacy
  6. Representative Bias
  7. Framing Bias
  8. Anchoring Bias
  9. Loss Aversion
  10. Herding Mentality

 

Overcoming Behavioral Finance Issues

Given all of the above, you may be concerned about how investors overcome these challenges. Below are two of the main strategies to guard against biases and decision-making errors.

 

#1 Focus on the Process

There are two approaches to decision-making:

  • Reflexive – Going with your gut, which is effortless, automatic and, in fact, is our default option
  • Reflective – Logical and methodical, but requires effort to engage actively

The more we rely on reflexive decision-making, the more prone we are to self-deception biases, heuristic simplification, influences of emotion, influences of herding, and being influenced by the behavior of others.

To mitigate against reflexive decision-making, it’s important to set up processes. Consider setting up processes that guide you through a logical decision-making approach and therefore help mitigate the use of reflexive decision making.

Get yourself focused on the process rather than the outcome. If you’re advising others, try to encourage the people you’re advising to think about the process again, rather than on the outcomes. Focusing on the process will lead to better decisions, because the process helps you engage your “Spock”-like reflective decision-making.

 

#2 Prepare, Plan and Pre-Commit

Behavioral finance teaches us to invest by preparing, by planning and by making sure we pre-commit. So, let’s finish with a quote from Warren Buffett.

“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.”

Learn more in CFI’s Behavioral Finance Course!

 

Additional Resources

Thank you for reading this guide. CFI is on a mission to help anyone become a world-class financial analyst with the Financial Modeling & Valuation (FMVA) certification.

To continue learning, these resources will be useful:

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