Behavioral finance versus traditional finance theory
Based on efficient market hypotheses, traditional financial theories assume that investors are rational and risk averse, and hold diversified, optimal portfolios. This assumes how investors “should” act based on mathematical models and theories. However, this does not always play out in practice.
In contrast, behavioral finance is based on understanding how people actually make financial decisions in practice. Behavioral finance suggests cognitive errors and emotional biases can impact financial decisions, often in a detrimental way. Cognitive errors are based on faulty reasoning (belief perseverance), or due to memory errors (information processing errors). Emotional biases stem from reasoning that is influenced by feelings or emotions, not fundamental facts.
Behavioral finance challenges the assumptions of traditional finance theory, recognizing that many investors do not make decisions in a rational manner. Investors are generally loss averse, and because their fears can get in the way, they do not necessarily hold optimal portfolios.
Behavioral finance suggests that people:
- Are not risk averse, rather they are “loss averse”
- Are not fully rational when making financial decisions
- Exhibit “asset segregation,” i.e., they often analyze investments individually, and not as a portfolio.
I believe understanding both traditional finance theory and behavioral finance can provide a better means to achieve one’s financial goals.
Emotional biases and associated behaviours
- Endowment: Believes an asset is more valuable because they own it. Holds assets based on emotional attachment (i.e., inheritance); misses out on potentially better opportunities.
- Herding: Follows the crowd. Invests with the consensus of a group; “If everyone is doing it, it must be correct;” doesn’t want to get left behind; avoids the feeling of regret; makes uninformed, inaccurate decisions.
- Loss Aversion: Has a stronger aversion to loss than to acquiring gains. Avoids assets with recent volatility; sells winners to lock in gains; holds losers in hope of breaking even.
- Regret Aversion: Experiences regret after making a decision. Regrets bad outcomes from decisions (sell, buy and hold); holds low-risk investments and ones that are familiar; demonstrates herding bias; feels safety in numbers.
Cognitive biases and associated behaviours
- Anchoring: “Anchors” to a specific value or number. “Anchored” to a high stock price and feels money was lost if stock trades below that price; doesn’t deviate from original forecast.
- Availability: Influenced by info that is easy to recall and relevant. Selects products based on advertising and media; remembers the pain; holds only assets they are familiar with.
- Confirmation: Looks for and notices info to confirm existing beliefs. Dismisses info that contradicts their beliefs. Demonstrates overconfidence in a specific investment, asset class, etc.
- Mental Accounting: Groups investments into separate “mental accounts.” Segregates wealth for different goals (i.e., college savings, retirement); ignores the correlation of assets.
The above excerpt has been taken from Mark Mobius' blog.
