The central issue in behavioral finance is explaining why market participants make systematic errors contrary to the assumption of rational market participants. Such errors affect prices and returns, creating market inefficiencies. It also investigates how other participants take advantage (arbitrage) of such market inefficiencies.
Some of the following traits know as heuristics follow.
Psychology concepts that affect the way you manage your investments.
In psychology and more specifically Behavioral Finance, heuristics are simple, efficient rules of thumb which people often use to form judgments and make decisions. They are mental shortcuts that usually involve focusing on one aspect of a complex problem and ignoring others. These rules work well under most circumstances, but they can lead to systematic deviations from logic, probability or rational choice theory.
The resulting errors are called "cognitive biases" and many different types have been documented. These have been shown to affect people's choices in situations like valuing a house or deciding the outcome of a legal case and in making financial decisions. Heuristics usually govern automatic, intuitive judgments but can also be used as deliberate mental strategies when working from limited information.
"Investors are 'normal,' not rational." Behavioral finance reconciles the discrepancy between rational valuation and irrational market pricing. It's a booming field of study. Top behavioral finance gurus include Yale's Robert Shiller and GMO's James Montier.
There are several common behavioral biases that drive investor decisions.
Availability Bias is the ease with which a particular idea can be brought to mind. When people estimate how likely or how frequent an event is on the basis of its availability, they are using the availability heuristic. When an infrequent event can be brought easily and vividly to mind, this heuristic overestimates its likelihood. For example, people overestimate their likelihood of dying in a dramatic event such as a tornado or terrorism. Dramatic, violent deaths are usually more highly publicised and therefore have a higher availability. On the other hand, common but mundane events are hard to bring to mind, so their likelihoods tend to be underestimated. These include deaths from suicides, strokes, and diabetes. This heuristic is one of the reasons why people are more easily swayed by a single, vivid story than by a large body of statistical evidence. It may also play a role in the appeal of lotteries: to someone buying a ticket, the well-publicised, jubilant winners are more available than the millions of people who have won nothing.
When people judge whether more English words begin with T or with K, the availability heuristic gives a quick way to answer the question. Words that begin with T come more readily to mind and so subjects give a correct answer without counting out large numbers of words. However, this heuristic can also produce errors. When people are asked whether there are more English words with K in the first position or with K in the third position, they use the same process. It is easy to think of words that begin with K, such as kangaroo, kitchen, or kept. It is harder to think of words with K as the third letter, such as lake, or acknowledge, although objectively these are three times more common. This leads people to the incorrect conclusion that K is more common at the start of words.
Investors believe they are awesome at investing
Overconfidence may be the most obvious behavioral finance concept. This is when you place too much confidence in your ability to predict the outcomes of your investment decisions. Overconfident investors are often under diversified and thus more susceptible volatility.
Investors are bad at processing new information.
Being poor and processing new information is known as Anchoring and is related to overconfidence. For example, you make your initial investment decision based on the information available to you at the time. Later, you get news that materially affects any forecasts you initially made. But rather than conduct new analysis, you just revise your old analysis. Because you are anchored, your revised analysis won't fully reflect the new information.
Investors connect the wrong things to each other.
Representativeness - A company might announce a string of great quarterly earnings. As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad behavioral finance concept called “heard investing.” A lot of investors incorrectly think one thing means something else. Another example of representativeness is assuming a good company is a good stock.
Investors absolutely hate losing money.
Loss aversion, or the reluctance to accept a loss, can be deadly. For example, one of your investments may be down 20% for good reason. The best decision may be to just book the loss and move on. However, you can't help but think that the stock might comeback.
This latter thinking is dangerous because it often results in you increasing your position in the money losing investment. This behavior is similar to the gambler who makes a series of larger bets in hopes of breaking even. This Heuristic leads largely into another heuristic known as gamblers Fallacy, which can be best described as flipping a coin 100 times and the first 99 flips have all been tales. Gamblers fallacy indicates that most of us would bet on the fact the next flip has to be heads. Even though the odds have not changed and as a standalone flip of a coin, the odds are still 50/50.
Investors have trouble forgetting bad memories.
How you invest your money in the future is often affected by the outcomes of your previous experience. For example, you may have sold a stock at a 20% gain, only to watch the stock continue to rise after your sale. And you think to yourself, "If only I had waited." Or perhaps one of your investments fall in value, and you dwell on the time when you could've sold it while in the money. These all lead to unpleasant feelings of regret.
Regret minimization (Fear of regret) occurs when you avoid investing altogether or invests conservatively because you don't want to feel that regret. This is the human psyches was of protecting ourselves from unwanted emotions.
Investors are great at coming up with excuses.
Sometimes your investments lose money. Of course, it's not your fault, right? Defense mechanisms in the form of excuses are related to overconfidence. Here are some common excuses:
- 'if-only': If only that one thing hadn't happened, then I would've been right. Unfortunately, you can't prove the counter-factual.
- 'almost right': But sometimes, being close isn't good enough.
- 'it hasn't happened yet': Unfortunately, "markets can remain irrational longer than you and I can remain solvent."
- 'single predictor': Just because you were wrong about one thing doesn't mean you're going to be wrong about everything else.