Behavioral Finance - An Introduction

As investors, we are often perplexed by the behavior of the markets. For instance, we may find a stock to be overvalued. Hence, ideally, the stock should drop in value and become fairly priced. However, in reality, it may keep on increasing in value, and the quantum of overvaluation may increase vastly. Similarly, we may find a share to be undervalued.

Hence, logically the share should increase in value and become fairly priced. However, in many cases, that does not happen. These occurrences often leave investors perplexed. This is because finance textbooks always teach them about a perfect world. However, when they actually witness the markets, it is far from perfect! Over time financial analysts have studied how the markets really work as opposed to how it should work. This information is codified in the subject of behavioral finance, which we discuss in this module.

Text Book Finance vs. Behavioral Finance

For the sake of simplicity, let’s combine that all the financial theories that we generally come across in finance and economics textbooks, and let’s call them textbook finance. The problem with textbook finance is that it depicts an idealistic world. It assumes that all investors have perfect information, i.e., they obtain information at about the same time. It also assumes that they have the mental faculties required to process this information in a rational and unbiased manner. Once these two assumptions are put into place, the rest of the theories can be explained in the form of mathematical equations.

However, we all know that this is not how the world works in reality. Neither do all market participants have access to perfect information, nor can they rationally process all the information and make informed decisions. The fact of the matter is that the decisions made by investors in the stock market are based on emotional factors. There are a wide variety of psychological processes as well as biases at play that influence how the decision finally gets made. These psychological processes and biases are explained in behavioral finance. In essence, behavioral finance is an amalgamation of finance as well as behavioral psychology.

Recursive Nature of Financial Markets

One of the things that make predicting the behavior of financial markets impossible is the recursive nature of the markets. This means that predictions about the future of the market actually affect the future of the market. For instance, if a person makes a weather prediction that it is going to rain tomorrow, their prediction will not actually influence the outcome. The prediction itself does not cause rain to happen.

However, in the case of financial markets, the world functions differently. If a seasoned investor like Warren Buffet were to make a prediction that the markets will fall in the future, it might spark fear amongst the market participants. This fear might actually spark a sell-off, and the price might go low. Hence, the prediction would act as a self-fulfilling prophecy in this case. This is largely because behavioral finance does not deal with atoms and molecules. Instead, the system is made up of people. These people can act in an irrational manner making the entire system unpredictable.

Individual Behaviour vs. Crowd Behaviour

Crowd psychology is the cornerstone of behavioral finance. The underlying assumption is that individuals behave differently as an individual as compared to when they are in a group. Since markets are formed of groups of people, the group tends to have an inordinate amount of influence on the behavior of individuals. The indices which depict market behavior (S&P 500) actually communicate the behavior of the group to the individual.

Evolution has primed individuals to adhere to group norms. This is why if an individual sees the market indices going in the red, they feel an urge to sell and confirm with the group behavior. This is because they feel that the group would have better knowledge than they have as individuals. Similarly, when the indices rise, there is a lot of pressure to buy into the hype and confirm with the collective decision of the group. Investors need to be emotionally mature in order to ignore this peer pressure and base their decisions on facts.

Why is Studying Behavioral Finance Important?

The entire philosophy of value investing is based on the concepts of behavioral finance. Value investing assumes that in the short run, markets are not efficient. Greed and fear take over and lead people to make irrational decisions.

Hence, if a person pays attention to behavioral finance, they can identify and understand these triggers. Behavioral finance helps a person from falling into common psychological traps. Instead, it helps them take advantage of the overvaluations and undervaluations which happen in the market because a large number of investors take decisions emotionally.

The ultimate goal of behavioral finance is to help investors make buy or sell decisions based on facts. This way, they can pre-empt the investors who wait for the market as a whole to recognize this error. By pre-empting the market and by staying rational, significant gains be can be made. Financial history is rife with investors who made millions in the dot com bubble, the housing market collapse, or any other crisis.

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