The study of behavioral finance tries to reveal the irrational behavior and decision-making law of the financial market.
According to behavioral finance, it is easy for investors to make suboptimal decisions because of the psychological influence that complicates our decisions.
The five most common behavioral biases of investors: loss aversion, anchoring effect, herd mentality, overconfidence and confirmation bias.
Detailed explanation of concept
Behavioral finance is a marginal discipline that intersects finance, psychology, behavior, sociology and other disciplines, trying to reveal the irrational behavior and decision-making laws of the financial market.
It is based on some factual premises, such as investors are not always rational, their self-control is limited, and their behavior is subject to their own prejudices.
To understand behavioral finance, we first need to understand the traditional theory of finance.
Traditional financial theory has three core hypotheses:
The individual has complete self-control.
Individuals have access and ability to know all relevant data and information before making a decision.
Individual decisions are always consistent.
In short, traditional financial theory points out that individuals always make the most rational decisions based on the objective facts available. However, irrationality is human nature. In fact:
We don't always have self-control.
We don't always have time or access to all the data and information before making a decision.
We are not always the same in decision-making.
The difference between behavioral finance and traditional financial theory is that it emphasizes the role of psychology in individual behavior.
According to behavioral finance, it is easy for investors to make suboptimal decisions because of the psychological influence that complicates our decisions.By understanding our different psychological reactions to emotions, we try to limit the impact of emotions on our investment decisions.
Five kinds of behavior biases affecting investors
Here, we list five common behavioral biases among investors, including loss aversion, anchoring effect, herd mentality, overconfidence and confirmation errors.
Investors are more concerned with losses than gains, a phenomenon called loss aversion. As a result, some investors may want higher returns than losses to compensate for their psychology. If they cannot get high returns, they may be inclined to avoid any losses. Even from a rational point of view, a certain investment risk is acceptable.
When an investment loses money, the aversion to loss will make many people choose to stick to it rather than sell and bear the loss.
The anchoring effect means that some investors make decisions with too much emphasis on previously obtained information (called anchors), even if the information has nothing to do with the decision. Investors with anchoring effect bias usually anchor the price of their investment at the original purchase price rather than the fundamentals.
The term herd instinct refers to the phenomenon that people join a group and follow the behavior of others. It is common in all aspects of society, including in the financial markets. Investors like to follow other investors they see rather than rely on their own independent analysis. Asset bubbles or market crashes caused by panic buying and panic selling are considered to be financial market phenomena caused by large-scale herding effects.
Overconfidence bias means that we are overconfident in our abilities, causing us to take too many risks. This bias is common in behavioral finance and can have a huge impact on capital markets.
Confirmation bias is a term in cognitive psychology that describes how people naturally prefer information that confirms their beliefs. Experts in behavioural finance have found that this basic principle applies particularly to market participants. Investors look for information that confirms their existing views and ignore contradictory facts or data. As a result, their cognitive bias may reduce the value of their decisions.