More than 2,300 years ago, the famous Greek
philosopher Aristotle stated that man is a rational animal and this
definition, in a way, has become the thesis of classical financial theory.
In this article we will explain what
behavioral finance means and how it differs from classical financial
theory. Read on and find out more about the top 6 cognitive biases, here we go!
Classical finance vs behavioral finance
Classical financial theory: this is its key principle
It is based on the hypothesis that
investors are perfectly rational and, therefore, thanks to this
peculiarity, they always manage to make the best decision in any
situation.
According to classical financial theory,
investors make rational decisions, acting based on a series of information
analyzed, precisely, in a rational manner.
But various empirical investigations, and
also history itself - just think of everything that financial crises have
taught us - have shown that individuals systematically make
mistakes.
What is behavioral finance?
Man is not only reason, but also instinct
and emotion, which is why he usually makes irrational decisions. This also
applies to the world of finance since investors are emotional. This is
the principle that gave rise to behavioral finance, that is, the
branch of economic studies that studies the behaviors of investors in financial
markets.
In contrast to the theory of traditional
finance related to the perfect rationality of individuals and the efficiency of
the market, an approach is proposed, on the one hand, alternative and,
on the other, complementary. In fact, this new school of thought starts from
the idea that markets are not completely efficient and that individuals are not
totally rational.
Behavioral finance recognizes that
emotions play an important role in investor decisions and seeks to
understand how they influence financial markets.
In other words, we could define behavioral
finance as a combination of economics, finance, and investment psychology .
Therefore, these finances, also known as emotional finances, directly influence
the investor's decision making.
Birth of behavioral finance
This branch of economics has experienced
great development in the last 3 or 4 decades, since it is in this period
of time when the most relevant publications and the most authoritative studies
have been concentrated.
But it doesn't hurt to know that to find
the origins of behavioral finance you have to go back further in time.
We can begin to talk about behavioral
economics already at the end of the 18th century with Adam Smith , author
of the book "Theory of Moral Sentiments", in which the famous
economist analyzes individual and social psychological behaviors.
However, neoclassical economists cut all
ties with psychology, giving life to the theory of homo economicus, considered
exclusively as a rational being.
Furthermore, we would have to wait until
the last century, specifically at the beginning of its second half, to witness
a return to the scene of behavioral finance.
The founding fathers: some basic principles
In 1979, the text "Prospect Theory: an
analysis of decisions under risk" was published, written by two Israeli
psychologists. These are Daniel Kahneman and Amos Tversky, considered
the founding fathers of behavioral finance.
In fact, with their perspective theory,
both psychologists focus on demonstrating how decisional processes in the
economic field undergo important modifications when the individual is in a
situation of investment risk.
Generally, human beings make their
decisions with the objective of avoiding losses or ensuring their gains. But
at the moment we find ourselves, in a context marked by uncertainty, an
asymmetry is created in the decision-making process. In fact, prospect
theory states that the weight of losses is much greater than that of
gains.
There is an asymmetry in valuation, showing
that the fear of loss is three times greater than the joy experienced when an
investment is successfully made. From this derives the concept of
loss aversion, one of the psychological phenomena formulated by Kahneman and
Tversky in their studies.
Among the founding fathers of behavioral
finance we also find Richard Thaler, winner of the Nobel Prize in
Economics in 2017.
Thaler is considered the founder of
behavioral economics, whose main theory is that human beings, in the economic
sphere, make fundamentally irrational decisions. Thus, we start from these
erroneous behaviors to arrive at an explanation of financial phenomena.
What behavioral finance is for?
The goal of behavioral finance is to
understand the way financial markets move, based on the behavior of each
individual or society.
In other words, this subfield of behavioral
economics tries to understand how investors act and the reasons behind the
decisions they make. As we have seen previously, one of the principles of
behavioral finance is that human beings are not completely rational.
Even in the financial field, their
decisions are conditioned by a series of external factors, known as cognitive
biases, which lead to mistakes, with often disastrous effects for the
individual, but sometimes, as a reflection, also for the markets.
Thanks to behavioral finance, these
erroneous and harmful behaviors are studied and once identified, an
important reading key can be offered, not only to understand what is at their
origin, but also to shed light on the logic of the market.
Thus, behavioral finance is an
indispensable tool because it helps optimize savings and investment management.
The research and studies carried out so far
have suggested to large investors the correct strategies to get the most out of
investments, even in the most complex phases of the market, when most
individuals tend to make more mistakes.
Cognitive errors and examples
As stated above, one of the main
principles of behavioral finance is: human beings systematically make errors
due to the absence of total rationality in their decisions.
These errors are defined as
"biases" or cognitive distortions and, thanks to their analysis,
theoretical models can be identified to resort to in order to make more
conscious decisions. It is important to highlight that, depending on the risk
profile, they may be found in different proportions.
It should be noted that biases are
divided into two categories: cognitive and emotional. Cognitive
biases are mental "shortcuts" used to avoid reasoning, while emotional
biases arise from some feeling or emotion, such as fear or desire.
1. Excess security
We speak of excess security when the
individual tends to overvalue his or her abilities, so he or she relies
exclusively on his or her perception, which he or she considers superior to any
objective evidence.
2. Risk aversion
The asymmetric perception of losses and
gains causes the individual to experience stronger pain for the former compared
to the pleasure felt for the latter which normally results in risk
aversion.
Because of this bias, it may happen that
you make a wrong decision driven precisely by the fear of a loss, which does
not allow you to correctly assess the potential gain.
As the investor profile plays an important role in decision-making, Forward You
has defined a risk model on a scale from "conservative" to
"offensive". This is how we find the appropriate investment
strategy based on personal appetite for risk.
3. Familiarity
The bias towards the familiar (" home
bias ") induces decisions to be made based on schemes already
explored and experienced previously.
This cognitive error leads the individual
to invest in stocks that they already know, excluding, for example, foreign
ones, which usually leads to a strong penalty in terms of diversification.
4. Anchoring
Anchoring is another bias with very
negative effects, because it is nothing more than the tendency to anchor
in the first information received and therefore in the first decisions made,
without evaluating other alternatives.
5. Herd effect
The herd effect is among the best-known
biases and is identified with the tendency to follow the behaviors of others, without
a rational approach that allows a conscious decision to be made.
For example, the herd effect can lead to
selling just because everyone is doing it, without anyone knowing that this is
the right option. At the same time, one could buy a security following the
euphoria of others, with the risk of being immersed in a speculative bubble.
6. Attribution error
One of the cognitive biases identified by
behavioral finance is represented by this error, which can be incurred once an
investment decision has been made.
Attribution error can lead to assigning
credit to oneself for decisions with positive results, and assigning blame to
others for those that went wrong.
Behavioral economics and neuroeconomics
In light of the underlying thesis from
which Thaler starts, it is not surprising that there is a close link between
behavioral economics and neuroeconomics, a discipline that studies the way in
which human beings make their decisions in the economic field.
What is the principle behind behavioral finance?
To understand the principle on which
behavioral finance is based, it is necessary to start from a consideration that
is as simple as it is basic: man is not only reason, but also instinct and
emotion, which is why he also tends to make irrational decisions.
How does behavioral finance come into play?
In essence, behavioral finance studies
markets in relation to people's behavior, thus trying to understand how they
are influenced by emotions and psychological aspects of the human being.
The key role of technology
The biases indicated above are just some of
the cognitive errors that directly influence the decisions made in the
financial field. Knowing that investment decisions can be conditioned
by this is, without a doubt, a very important first step.
The merit of all this must certainly be
given to behavioral finance, which helps us by providing us with models to
be able to decide better and more rationally.
But knowing behavioral anomalies is no
guarantee of success, because this is usually not enough to avoid the
repetition of errors of which we are also aware. And this is where technology
becomes decisive, allowing us to avoid the biases that induce human beings
to pay attention to their emotions instead of their rationality.
Think, for example, of artificial
intelligence that, free of any form of emotion, guarantees rational
treatment of investments, especially in the most difficult market
situations.
In summary
Behavioral finance:
- They start
from the principle that human beings are not totally rational.
- They try
to understand how investors act
- They study
cognitive errors, biases, of human beings
- They
provide models based on which to decide better and more rationally.
Did you know…
Did the concept of behavioral economics
spread at the end of the 18th century, with Adam Smith?
Behavioral finance is necessary to optimize savings and investment management.
0 Comments