Behavioral Finance

Published Aug 10, 2023

Definition of Behavioral Finance

Behavioral finance is a field of finance that studies the psychological and behavioral aspects of financial decision-making. That means it looks at how people make decisions about money and how those decisions are influenced by their emotions, beliefs, and biases. It is a relatively new field of finance that combines elements of psychology, economics, and finance to better understand how people make financial decisions.

Example

Imagine an individual named Sarah who is an experienced investor. She’s been following a particular technology company closely and believes that its innovative products will revolutionize the market. Based on her research, she buys shares of the company at $50 per share, expecting the price to increase significantly over the next few years.

Initially, the stock price does rise to $70 per share, and Sarah’s investment is showing a decent profit. However, a few months later, the company faces some negative news related to a minor product recall due to a manufacturing defect. As a result, the stock price starts to drop, and it goes down to $40 per share.

Now, let’s see how behavioral finance concepts come into play:

1. Loss Aversion: Due to loss aversion, Sarah’s emotional reaction to losses is stronger than her reaction to gains. Even though the stock was initially purchased at $50 and is still higher than that, the fact that it dropped from $70 to $40 triggers anxiety and discomfort.
2. Anchoring: When the stock was at $70, Sarah anchored her expectations to that higher price. The subsequent decline to $40 makes her feel that the stock has lost significant value, even though it might still have long-term potential.
3. Disposition Effect: The disposition effect suggests that investors tend to hold onto losing investments for too long and sell winning investments too quickly. In this case, if Sarah succumbs to the disposition effect, she might hold onto the stock hoping it will recover to $70 and end up selling at a lower price than her initial purchase price.
4. Herd Behavior: Seeing the stock price drop and facing negative news, Sarah might start doubting her initial analysis and research. She might also observe other investors selling their shares in panic, contributing to her fear of missing out on some “inside information.”
5. Confirmation Bias: Sarah might actively seek out information that confirms her fears about the stock’s future performance. She might focus on negative news and ignore any positive developments that could still support her original investment thesis.
6. Overconfidence: Before the decline, Sarah might have been overly confident in her analysis and the stock’s potential. The setback challenges her initial beliefs and makes her question her own judgment.

As a result of these behavioral biases and tendencies, Sarah might end up selling her shares at $40, even though the fundamental value of the company’s products and potential might not have changed. This decision could lead to a missed opportunity if the stock eventually rebounds and reaches higher values.

This example underscores how emotions, biases, and psychological factors can influence investment decisions, often causing investors to deviate from rational, value-driven choices.

Why Behavioral Finance Matters

Behavioral finance is an important field of finance because it helps us to better understand how people make financial decisions. By understanding the psychological and behavioral aspects of decision-making, we can develop better strategies for investing and managing our finances. In addition, it can also help us to identify and avoid common mistakes that people make when it comes to money. Finally, it can also help us to develop better financial products and services that are tailored to the needs and preferences of individual investors.