Psychological influences – such as emotions and biases – impact how a person thinks, behaves and makes decisions. It’s likely that these influences, both conscious and subconscious, impact nearly every aspect of your life – including how you spend, save and invest your money. The study of how these influences impact investors’ decision-making is known as behavioral finance.
This guide takes a closer look at what behavioral finance is and how understanding the influence these factors have on your investment decisions can help improve your overall investment strategy.
What is behavioral finance?
Behavioral finance is the study of how psychological influences, such as emotions like fear and greed, as well as conscious and subconscious bias, impact investors’ behaviors and decisions. It removes the misconception that investors always make rational decisions that are in their best interest. It acknowledges that emotions and biases can impact investing decisions, even if it goes against a person’s own self-interests.
Behavioral finance and the stock market
The efficient market hypothesis (EMH) makes the assumption that the price of securities, such as stocks, already factors in all known information about that security. This hypothesis holds the belief that while individual investors may not always act rationally, the stock market as a whole is always right. On the contrary, the study of behavioral finance believes that external factors, such as greed, fear, anger and bias, also contribute to stock prices and market fluctuations.
Behavioral finance is such an influential factor impacting the stock market that the Security and Exchange Commission has a dedicated team studying its impact. Understanding how these factors impact the stock market can help you make investment decisions that are based on the most relevant facts and not just your gut instincts or emotions.
Understanding behavioral economics
As an investor, it’s valuable to explore how various emotions and biases may impact your investment decisions. The reality is that we all have biases, whether conscious or unconscious, that affect the way we think, act and behave. It only makes sense that these factors could influence what choices you make when it comes to investing.
While it’s impossible to remove all types of emotions and biases, you can learn more about these factors and how they influence not just your thought process but investment markets as well. This type of understanding can help you identify outside factors that may influence your investment decisions and encourage you to take a closer look at other factors, such as facts and data, before making investment decisions.
The 5 behavioral finance concepts
There are many psychological influences that impact your behaviors and decision-making, but the vast majority of these factors can be broken down into one of the following five behavioral finance concepts.
Mental accounting is a behavior where investors place different values on various forms of money and investments. For instance, an investor may place more value on paying off their mortgage than contributing to long-term investments. This type of thinking can cause investors to make financial decisions that are counterintuitive to their interests.
Herd behavior is the practice of following the actions of a group of people despite the lack of a clear plan or vision. In finance, it occurs when investors make rash investment decisions based solely on the behaviors of other investors. In many cases, investors make these decisions despite not understanding the drivers behind these trends. Herd behavior can lead to fast-paced sell-offs or rallies. Unfortunately, in some cases, this type of investment practice can also lead to significant losses.
Have you heard the old phrase that the only two factors driving the investment markets are fear and greed? These two factors along with other powerful emotions, such as anger and excitement, can indeed have an extreme impact on an investor’s decision-making process.
These factors, known as the emotional gap, can cause investors to make irrational decisions based on their emotions rather than focus on hard facts and professional advice. For example, an investor’s desire to "get rich quick" can cause them to make risky investments for a promise of fast returns. On the other hand, fear can prevent investors from making sound investment decisions or entice them to prematurely sell off assets at the first sign of trouble.
Anchoring is the subconscious practice of relying solely on assumptions when making investment decisions. According to Herbert Simon, a leading behavioral economist, investors often use heuristics – or mental shortcuts – when making complex or difficult investment and financial decisions. Rather than focus on facts and data, investors use past experiences and general rules to make assumptions regarding investments.
For example, an investor may assume that when a stock performs well over the last 5 years, it will continue to perform well in the future. Without also looking at other factors that may impact the stock’s performance, the investor’s assumption may not hold true. On the other hand, an investor may fail to take advantage of a promising investment opportunity due to a bad experience with a similar investment.
Self-attribution occurs when an investor is overconfident in their investment knowledge and abilities. This type of investor often takes all the credit when an investment performs well but steers the blame away from themselves when an investment underperforms. For example, if an investor purchases stock that suddenly increases in value, the investor takes all the credit for the outcomes of this decision despite not using any facts or insights when making this purchase. If, on the other hand, this stock suddenly takes a downward turn, the investor may blame it on bad luck rather than themselves.
Self-attribution can be dangerous because it can lead investors to make rash decisions based solely on gut instincts. Investors who become overconfident without ever evaluating previous investment mistakes could end up losing significant amounts of money.
Behavioral finance biases
Emotions aren’t the only factor impacting investors’ decisions. Both conscious and subconscious biases also influence how investors make decisions. While studies show that there are over 180 cognitive biases1 that impact the way we think and make decisions, there are four primary types of behavioral finance biases.
Confirmation bias occurs when an investor quickly accepts any information that aligns with their own personal beliefs as a fact. Due to this type of bias, investors are more likely to believe that this type of information is correct without any facts or data to support it. Confirmation bias can also make investors less likely to accept facts that go against their already-held beliefs. This bias could entice you to select underperforming investment options or fail to determine when the right time to sell is.
Experiential bias is when investors make investment decisions based primarily on past events. Investors believe that current events are likely to have similar outcomes and, therefore, base their investment decisions on this information. While using historical data can be beneficial when making investment decisions, there are many other factors that you need to consider. Recency bias is a similar factor that occurs when investors choose their investment options based on current trends. This also can be a dangerous practice because many trends are short-lived.
For example, during the recession of 2008, many investors sold off their stocks in anticipation of a stock market crash. While the stock market definitely saw turbulence during this timeframe, it technically never crashed and saw a recovery in a little over a year.
Loss aversion can be a particularly strong bias, especially for new investors. It occurs when an investor focuses more on the potential losses attached to an investment instead of focusing on the gains they may potentially make. As an investor, it’s important to set your own risk level, but you can’t let the potential risks involved hinder your ability to properly assess each investment you are considering.
Familiarity bias occurs when investors tend to focus primarily on investment options that they are already familiar with, such as money market funds, CDs or domestic stocks. This might be a good strategy for some new investors, but over time, it’s important to develop a diversified investment portfolio.
What is an example of behavioral finance?
One way to fully understand the impact behavioral finance can have on your investment decisions is to take a look at an example.
Let’s say that someone files a major lawsuit against a company you currently invest in. Your experiential bias tells you that similar events spur a significant drop in stock prices. Based on this information, you’re likely to sell your stock as quickly as possible to minimize your losses. Even if you decide to hold onto this stock for a while, the influence of herd behavior may entice you to follow many other investors' leads and sell your stock, even at a loss.
However, basic research could show that the lawsuit is likely a ploy by the plaintiff to reach a higher settlement with the company. If you only use your emotions and biases to determine when the right time to sell your stock is, you could end up losing money on your investment. If, on the other hand, you hold your stock until the parties reach a settlement, you may see better outcomes. In this scenario, the investor would have had better outcomes if they would have researched the reasons for the lawsuit before making assumptions.
It’s important to understand how your emotions and personal biases can impact your investment choices. With this understanding, you can take steps to minimize the effect these influences have on your decision-making process and maintain focus on your long-term plan.
It’s important to maintain a long-term focus. If you look at why individual investors haven't done as well as the indices, it's because of emotional mistakes – selling at the wrong time, being fearful, doing things that we wouldn't normally do if we weren't scared.
Now is a good opportunity to go back to who you are as an investor, which is your risk tolerance. How much volatility can you stomach?
Control what you can. Make sure that you build a strategy that you’re comfortable with. The best strategy for any investor is the one that they stay in.
You can exert control through better diversification and portfolio rebalancing. And this can make a difference when we experience market volatility.
When it comes to a long-term approach, we want to focus on the things we can control, and ultimately, at the end of the day, can provide better peace of mind and more confidence, knowing that your portfolio is designed to weather market storms.
Consider meeting with a financial professional who can provide you with guidance to make more informed investment decisions.