Behavioral finance is not only a popular topic in investment, but also an important area in ACCA Advanced Financial Management exam. Understanding behavioral finance is now more important than before as it helps finance managers to make right finance decision avoiding those “traps”.
Finance decisions are the most critical, calculated, and audited decisions in an economic market. The common notion with financial decisions is that every decision taken is a well thought and rational one. Still, we see a lot of Finance decisions being criticized and the results justify that criticism. With all the rationality and reasonability still a few certain events cannot be explained e.g. a failed acquisition or merger.
Similarly, in Stock markets, all the stock prices should reflect the true information available about the company and economy, yet we see a sudden rise and fall in the stock markets. Efficient Market Hypothesis (EMH) states that in a well-informed (fully efficient) market all stock should reflect the available information.
Depending on the market efficiency the stock prices may lag behind the information reflection, but why does it lag in a fully efficient market?
What is Behavioral Finance?
Behavioral finance is the modern concept of finance which explains the unpredictability in finance decisions taken in a real life scenario that defy rationality.
“The influence of psychology on behaviors on financial practitioners”: Swell, 2005.
These behaviors can be studied both individually and as a whole on the macroeconomic level. Theoretically, investors must make well informed, unbiased, and rational decisions on investments to maximize their returns.
Often the investors’ decisions about stock investments or divestments are irrational, biased, and unpredictable. The traditional EMH hypothesis argues that in an efficient market all investors have access to all the necessary available information. Practically though not all investors are well informed to make decisions on stocks, additionally many psychological and emotional factors affect their decision making.
As of today, the rapid pace of information and events makes it impossible to interpret and analyze all the information about stocks. Not only all the financial and internal factors but external factors such as political scenarios affect the stock prices. Hence even the most efficient markets cannot truly reflect the effects of all the related information, the weakness or lower efficiency of markets makes it even harder.
For all investors, two important factors play an important part before making any stock investment decision, historical performance and future predictions.
Traditionally, the EMH theorists categorize these two as fundamental and technical aspects. Lack of market efficiency apart, investors’ behavior played an important role in practical decision making over the years. If the past performance reflects on current stock price, if the rational bases hold and the forecasts can be made about a stock performance.
Yet we see some stocks rapidly changing prices, both ways. For example, in a market recession as recently as coronavirus caused 2020, some of the stocks went up in prices. This phenomenon is a true reflection of the finance behavioral study of investors; market data, forecasts, trends, and predictions all pointed downwards slump, yet few stocks appraised their valuation.
Behavioral finance is a relatively newer field of study, so drawing conclusive and evidential prescriptions would be a naïve approach. However, behavioral finance does explain some of the investor behaviors which traditional financial hypothesis cannot explain logically.
Behavioral finance argues many factors play an important part in investor decision making, such as bias, herd attitude, anchoring, etc. we’ll discuss few of these aspects in relation to the finance decision-maker behaviors about stock investments.
Cognitive Dissonance
We make decisions daily, some based on facts and others on choices, our choices are made based upon certain factors such as emotional attachment, prejudice, information etc. Investors also make decisions based on several thoughtful factors. When we receive new information, sometimes our decisions seem wrong or irrational. That can cause psychological discomfort, and we try to persist with our original decision or try to justify it.
This biased psychological behavior is called cognitive dissonance. Investors do also face cognitive dissonance, often when their investment decisions prove wrong. The bias attached to a certain stock (company); through the emotional attachment and established information can be positive or negative.
Many factors such as risk-aversion, herd attitude, and confirmation bias can lead investors to cognitive dissonance if proven wrong.
This cognitive dissonance factor can affect an investor’s decision making in financial decisions too:
Investors would continue to invest in stocks when it keeps going down, to justify their earlier decisions
Investors would hold the stocks even if their prices fall, to avoid the mental discomfort.
Investors would hope for a different result in anticipation, even if previous stock information suggests otherwise. (Gambler’s fallacy discussed later)
Investors will put weight on information only aligning with their investment decisions- Confirmation bias
Gambler’s Fallacy
Financial study considers each event as an independent even, regardless of previously followed by the pattern or trends. In other words, each event needs to be justified on its own. Investors matching the probability concepts in investments, sometimes behave with a certain bias of choices.
For example, if a particular company stock keeps rising for a certain period, the investors would think today the stocks will fall. This is observed as a Gambler’s fallacy, the dice will fall my way this time. It occurs when an individual erroneously believes that a certain random event is less likely or more likely, given a previous event or a series of events.
This investor behavior contradicts traditional probability concepts of financing. Behavioral finance tries to explain this scenario through investors’ behavioral choices. Investors with such financial behavior may opt to sell a profitable stock, buy or hold a loss-making stock erroneously anticipating the opposite result.
Anchoring Bias Behavior
This financial behavior is linked with misuse of received information. Anchoring and adjustment behavior can be observed anywhere, from retail customers to financial strategists.
For example, in real estate business when negotiating prices for a property the buyer would compare prices in a similar market real estate rather than actual costs and profits of the property under consideration. Their adjustment would also revolve around the initial price quoted by the seller, i.e. the anchor of the decision.
For investors, historical performance information and past stock valuations are common anchors. This anchoring behavior can also play a positive role when dealing with an extensive amount of information. Investors often fail to adjust to newer information about their investments.
As argued by traditional finance theories any rational investor would take into account this new information and adjust the future investment decision. Behavioral finance explains the irrational decision making or failing to adjustments with new information as “anchoring bias”. This phenomenon can lead investors to hold the loss-making stocks for too long or to purchase the loss-making stocks.
Herd Instinct
As a common observer, you would have often examined the panic buying behavior of customers. People start buying certain commodities in a fear of shortage or unavailability, regardless of the assurances.
Similarly, investors start buying or selling certain stocks following others rather than rationally following individual instincts. Stock market bubbles are caused by such herd instinct behaviors when more investors start purchasing a certain stock.
At a certain point, the stock price reaches a point that investors refuse to pay, which bursts the bubble. The repercussions of the investment bubble caused by herd instinct are often long-lasting then short-term gains due to stock price appreciation.
Confirmation Bias
This behavior is closely related to cognitive dissonance when investors receive information opposing their beliefs they find ways to alleviate that discomfort.
Investors accept or appreciate the information only aligning with their choices and beliefs, and disregard any opposing information, this is confirmation bias. Investors strain out important information about the certain stock performance or predictions in a way that supports their perception.
In a stock market, this behavior also leads investors towards over-confidence. To some extent, investors persistent although irrational choices for certain stocks explain the inefficiency of stock markets in line with EMH.
Limitations of Behavioral Finance Theory
Behavioral finance explains important investors’ decisions making reasoning that modern portfolio theory or efficient market hypothesis fails to explain.
Theoretically, every market should reflect the ideal level of available information and investors should make rational decisions. In a practical world, that often doesn’t happen. Still, behavioral finance possesses its own limitations.
Behavioral finance fails to explain investors’ behaviors for a long-term period. As most of the investor irrigational or psychological behavior led decisions are short-term.
No investing or financial decision would make sense if we discard the EMH rationality and neutrality characteristics of investor decisions.
Investors’ persistence with behavioral factors such as herding or anchoring would result in failures, which in the long-term should rectify the approach but it doesn’t.
Some of the psychological behavior patterns identified by behavioral finance theory contradict, for example, a Gambler’s fallacy effect would push an investor to take a different investment decision than an investor falling prey to the herd instinct.
Behavioral finance theory tries to explain the practical attitude and decision-making process of investors. If the market is not efficient or semi-efficient, how would an investor make the decision?
Even with a fully efficient market, reflecting true effects of a company’s performance on stocks, the investors would still make some decisions irrationally. Human instinct of emotional bias, herd following, and confirmation bias are only a few of the psychological factors that explain irrationality in finance decisions. However, if all investor behavior is perceived to be led by psychological behaviors then any financial decision can be dubbed as irrational.
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