Behavioural Finance Impact on financial markets and individual investors

Traditional finance With its simplifying assumption of rational investors and efficient markets, traditional finance has gained wide acceptance among academics and investment professionals as a guide to financial decision making. Over time, however, the limitations of traditional finance have become increasingly apparent. Individual decision making is not nearly as objective and intellectually rigorous, and financial markets are not always as rational and efficiently priced as traditional finance assumes.

To bridge this gap between theory and practice, behavioral finance approaches decision making from an empirical perspective. It identifies patterns of individual behavior without trying to justify or rationalize them. A practical integration of behavioral and traditional finance may lead to a better outcome than either approach used in isolation.

By knowing how investors should behave and how investors are likely to behave, it may be possible to construct investment solutions that are both more rational from a traditional perspective and, because of adjustments reflecting behavioral insights, easier to accept and remain committed to. Although these behavioral insights will not lead easily or automatically to superior results, it is hoped that they will help many improve their investment approach and enhance risk management.

Assumptions of traditional finance Traditional finance assumes that investors are rational i.e. investors are risk-averse, self-interested utility-maximizers who process available information in an unbiased way. Traditional finance assumes that investors construct and hold optimal portfolios; optimal portfolios are mean–variance efficient. Traditional finance hypothesizes that markets are efficient: Market prices incorporate and reflect all available and relevant information.

Assumptions of behavioral finance Behavioral finance makes different (non-normative) assumptions about investor and market behaviors. Behavioral finance attempts to understand and explain observed investor and market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance. Behavioral biases are observed to affect the financial decisions of individuals.

Bounded rationality is proposed as an alternative to assuming perfect information and perfect rationality on the part of individuals: Individuals are acknowledged to have informational, intellectual, and computational limitations and as a result may satisfice rather than optimize when making decisions. Prospect theory is proposed as an alternative to expected utility theory. Within prospect theory, loss aversion is proposed as an alternative to risk aversion.

Impact on financial markets Markets are not always observed to be efficient; anomalous markets are observed. Theories and models based on behavioral perspectives have been advanced to explain observed market behavior and portfolio construction. One behavioral approach to asset pricing suggests that the discount rate used to value an asset should include a sentiment risk premium.

Behavioral portfolio theory suggests that portfolios are constructed in layers to satisfy investor goals rather than to be mean–variance efficient. The behavioral life-cycle hypothesis suggests that people classify their assets into non-fungible mental accounts and develop spending (current consumption) and savings (future consumption) plans that, although not optimal, achieve some balance between short-term gratification and long- term goals.

The adaptive markets hypothesis, based on some principles of evolutionary biology, suggests that the degree of market efficiency is related to environmental factors characterizing market ecology. These factors include the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants.

By understanding investor behavior, it may be possible to construct investment solutions that will be closer to the rational solution of traditional finance and, because of adjustments reflecting behavioral insights, easier to accept and remain committed to.

Behavioural biases Behavioral biases potentially affect the behaviors and decisions of financial market participants. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and as a result improve upon economic outcomes. These biases may be categorized as either cognitive errors or emotional biases. The type of bias influences whether the impact of the bias is moderated or adapted to.

Individuals do not necessarily act rationally and consider all available information in the decision- making process because they may be influenced by behavioral biases. Biases may lead to sub-optimal decisions. While behavioral biases may be categorized as either cognitive errors or emotional biases, a single bias may, however, have aspects of both with one type of bias dominating.

Cognitive and emotional Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors typically result from faulty reasoning. Emotional biases stem from impulse or intuition; emotional biases tend to result from reasoning influenced by feelings. Cognitive errors are more easily corrected for because they stem from faulty reasoning rather than an emotional predisposition.

Emotional biases are harder to correct for because they are based on feelings, which can be difficult to change. To adapt to a bias is to recognize and accept the bias and to adjust for the bias rather than to attempt to moderate the bias. To moderate a bias is to recognize the bias and to attempt to reduce or even eliminate the bias within the individual.

Cognitive errors can be further classified into two categories: 1.Belief perseverance biases 2.Information-processing biases

Belief perseverance biases Belief perseverance errors reflect an inclination to maintain beliefs. The belief is maintained by committing statistical, information-processing, or memory errors. Belief perseverance biases are closely related to the psychological concept of cognitive dissonance. Belief perseverance biases include conservatism, confirmation, representative-ness, illusion of control, and hindsight.

Belief perseverance biases explained 1.Conservatism: A belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information. 2.Confirmation: A belief perseverance bias in which people tend to look for and notice what confirms their beliefs, to ignore or undervalue what contradicts their beliefs, and to misinterpret information as support for their beliefs. 3.Representativeness: A belief perseverance bias in which people tend to classify new information based on past experiences and classifications.

4.Illusion of control: A bias in which people tend to believe that they can control or influence outcomes when, in fact, they cannot. Illusion of knowledge and self-attribution biases contribute to the overconfidence bias. 5.Hindsight: A bias with selective perception and retention aspects in which people may see past events as having been predictable and reasonable to expect.

Information processing biases Information-processing biases result in information being processed and used illogically or irrationally. Information-processing biases include anchoring and adjustment, mental accounting, framing, and availability.

Information processing biases explained Anchoring and adjustment: An information- processing bias in which the use of a psychological heuristic influences the way people estimate probabilities. Anchoring trapThe tendency of the mind to give disproportionate weight to the first information it receives on a topic. Mental accounting: An information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.

Framing: An information-processing bias in which a person answers a question differently based on the way in which it is asked (framed). Availability biasAn information-processing bias in which people take a heuristic approach to estimating the probability of an outcome based on how easily the outcome comes to mind.

Emotional biases explained Loss aversion: A bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains. Overconfidence: The tendency of individuals to overestimate the accuracy of their forecasts. Self attribution bias: A bias in which people take personal credit for successes and attribute failures to external factors outside the individual’s control.

Self-control: A bias in which people fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline. Status quo: An emotional bias in which people do nothing (i.e., maintain the “status quo”) instead of making a change.

Endowment: An emotional bias in which people value an asset more when they hold rights to it than when they do not. Regret aversion: An emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly.

Understanding and detecting biases is the first step in overcoming the effect of biases on financial decisions. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and as a result improve upon economic outcomes.

Classifying investors into investor types based on their characteristics, including level of risk tolerance, preferred approach to investing, and behavioral characteristics and biases, is useful for providing insight and financial decision making but should be used with some caution. Adviser–client relations and financial decisions will be more effective and satisfying if behavioral factors are taken into account.

Including behavioral factors in portfolio construction may result in a portfolio that is closer to the efficient portfolio of traditional finance, while being easier for the client to understand and accept as suitable. By considering behavioral biases, it is possible to moderate their effects.

All market participants, even those with significant knowledge of and experience in finance, may exhibit behavioral biases. Analysts are not immune. Analysts, in general, are prone to overconfidence, representativeness, availability, illusion of control, and hindsight biases. Awareness of their biases and their potential influences can help analysts put in place measures to help moderate the effect of these biases.

Analysts interpreting information provided by management should consider and adjust for the biases that analysts and management teams are typically susceptible to, including framing, anchoring and adjustment, availability, and overconfidence. Management biases can affect both the choice of information presented and how it is presented. These may have an effect on the analysis.

Committees often have the responsibility for making investment decisions and are subject to behavioral biases. It is important to implement procedures to alleviate the effect of behavioral biases and improve committee decision making. Behavioral finance has the potential to explain some apparent deviations from market efficiency (market anomalies).