According to conventional, or modern, financial theory, people are generally rational and predictable investors. Some popular conventional finance theories are the Capital Asset Pricing model, which explains the relationship between systematic risk and expected return, and the Efficient Market Hypothesis, a theory that claims it is impossible to beat the market because stocks always trade at fair value. And while these theories sufficed for a while, critics began to notice that these theories couldn’t explain certain “irrational” investor behaviors.
Behavioral Finance is the study of these irrational behaviors, and how emotions can drive the stock market. This idea that psychology is a driving factor in market changes is a direct challenge to traditional economic theory, but the reality is that even sensible investors make irrational decisions.
Loss aversion is a fundamental part of Behavioral Finance, and can be explained by the Prospect theory, which states that people make decisions based on the potential value of losses and gains rather than final outcome1. Here is an experiment from Science2 that illustrates this loss aversion:
Participants in the study were given $50 at the start of the experiment. They were then asked to choose one of two options, 1. Keep $30 or 2. Gamble with a 50/50 chance of losing the whole $50. The results were that 43% of people chose to gamble.
The experimenters then changed the way the secure option was worded, asking participants to choose between, 1. Losing $20 or 2. Gambling with a 50/50 chance of losing the whole $50. The results this time? The participants who chose to gamble rose to 61%. People are more likely to prioritize avoiding a loss than the possibility of a greater gain. This translates into investors holding on to investments that continue to lose money, believing they can avoid loss because the price will eventually come back.
Loss aversion causes investors to become reluctant to make a change because they are so focused on what they might lose, instead of what they could potentially gain – a phenomenon known as “inertia”. This inertia is what causes people to put things off that they know is in their best interest, like saving for retirement, but find it hard to actually do today.
Herd instinct is the tendency for an individual to act the same way as the majority of those around them. In investing, this is seen when people want to invest in certain stocks solely because many others are investing in those stocks. Investors often will fear that others know more information about a stock, and they will be left behind if they do not also invest.
This herd mentality is what can cause investment bubbles. While some bubbles certainly occur naturally, others are due to investors’ pressing fear that they will be left behind and miss the huge gains if they do not buy when everyone else does. The dotcom bubble of the late ‘90s is a perfect example of herd mentality, with people buying up stocks based on pure conjecture.
The concept of anchoring in investing is seen when an investor fixates, or “anchors”, on a single piece of information, rather than taking all relevant information into account when making a decision on an investment. Investors may invest in a stock company that has had a recent high, even if by the time they invest the company has fallen considerably in a brief amount of time. In this case, the investor fixates on the high, believing they are getting a deal by buying the stock low before it comes back up, even though there is no real evidence that the stock will ever come back.
What Does Behavior Finance Tell Us?
In the end, behavioral finance is used by few investors to predict the type of returns certain investments will offer. While from an academic viewpoint, it provides a great deal of insight into the mind of the investor, behavioral finance does little to provide solutions to the problems.
For now, behavioral finance is a useful theory that helps us explain the economic happenings of the past. But until behaviorists can produce a model that actually predicts the future of the market, conventional financial theory remains king.
At Walsh & Associates, we hope that knowing behavioral finance fundamentals will help our clients train themselves to avoid falling into these irrational behaviors. Concerned that you’ve fallen into some of these traps with our own investments? We’re happy to review your current financial situation, just give us a call or contact us online.
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