The study of behavioral finance focuses on how psychology affects investors and financial markets. It explains why investors often lack self-control, act against their own interests, and make decisions based on bias instead of factual information.
An important aspect of behavioral finance is the identification and explanation of financial market inefficiencies and mispricings. It demonstrates that humans and financial markets do not always make rational decisions and often make mistakes. Behavioral finance offers answers and explanations to questions about how emotions and biases affect share prices.
Psychologists Daniel Kahneman and Amos Tversky and economist Robert J. Shiller developed behavioral finance in the 1970s and 1980s. They studied how people make financial decisions based on pervasive, deep-seated, subconscious biases and heuristics. Meanwhile, finance researchers began to suggest that the efficient market hypothesis (EMH), a popular theory that the stock market moves rationally and predictably, isn’t always correct. The reality is that markets are filled with inefficiencies because investors often think incorrectly about price and risk.
Understanding Behavioral Finance Biases
Cognitive biases result from inaccurate judgments and beliefs based on economic and financial assumptions. Some of the most common cognitive biases are:
- Self-attribution bias: Assuming that good investment results are the result of skill, while undesirable results can be attributed to unlucky circumstances.
- Confirmation bias: Concentrating on information that confirms a finance or investment belief and ignoring contrary information.
- Representative bias: Overestimating the correlation between two events or things.
- Framing bias: Taking action based on how an opportunity is presented.
- Anchoring bias: Getting swayed by the first price or number encountered.
- Loss aversion: Focusing on avoiding losses more than on recognizing gains, thus missing out on desirable investment or finance opportunities.
These biases and the methods that helped create them affect investor behavior, market and trading psychology, cognitive errors, and emotional reasoning.
How to Reduce Effects of Financial Bias
In order to reduce the effects of financial bias on decision-making, it’s best to assume that you have these biases. The following investment strategies can also help you avoid the traps they create:
- Passive investing has the potential of eliminating the possibility of making mistakes when reacting to market events.
- Value investing can be viewed as contrarian. This is often a distinct position on prices created by market bias.
- Financial bias can also be mitigated by ensuring broad asset allocation. Regardless of your feelings about an asset class, it could be in your interest if you had capital in other uncorrelated asset classes.
Final Thoughts on Behavioral Finance
Understanding behavioral finance has two advantages. First, being aware of the biases that can affect your decisions can help you avoid making them. Second, you can make use of the knowledge. At Hiley Hunt Wealth Management, we understand that not everyone is the same. Each person has their own unique circumstances and goals. We work with you to understand your current financial situation and where you want to be in the future. We help you create an investment portfolio that is balanced and can help you achieve your goals. To get to know us better, contact us today.