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Behavioral Finance

Last Updated: 6/14/2022
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What Is Behavioral Finance?

Behavioral finance is the study of how individual psychology, including cognitive biases, affect the financial decisions of individuals.This field of study examines how psychological factors can lead to poor decisions that negatively impact wealth. The discipline applies to both personal financial decisions and personal and institutional investment decisions.

There are a lot of real-world examples supporting behavioral finance theory. For instance, when the U.S. stock market recorded its biggest one-day percentage drop during the Black Monday crisis in October 1987. Robert Shiller, a renowned economist, found it was due to investors’ expectations of an impending crash.

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Understanding Behavioral Finance

Behavioral finance theory aims to help understand financial choices and how these affect markets. It focuses on the role of personal biases when making financial decisions. Unlike traditional finance theory, behavioral finance states that individuals can be emotional and have limited self-control when it comes to their finances. However, they are able to assess these errors and biases which can help them make rational and informed financial decisions.

Prospect Theory and Behavioral Finance

In studying behavioral finance, it is important to understand prospect theory. Originally conceived by Daniel Kahneman and Amos Tversky in 1979, this underlying theory describes how individuals view risk and reward.

For instance, a person is given $1,000. Then, they are asked to choose between a 50% chance of getting another $1,000 and 100% chance of getting $500. The study showed that more people will choose the latter option. However, if they are given $2,000 and are asked to choose between a 50% chance of losing $1,000 and a 100% chance of losing $500, they will choose the gamble.

Loss aversion theory is an aspect of prospect theory and can be represented in an S-curve shape with “value” on the y-axis and “Loss/Gain” on the x-axis.

The theory states that people value losses and gains differently. People tend to take the risk if there is a 50% chance of losing or giving up something, but they tend to choose options where they believe they will have a 100% chance of benefiting from the choice. One aspect of prospect theory is loss aversion theory, meaning people tend to view losses to be far worse than gains with a similar chance outcome. You can see this in the s-curve graph above. The loss of $500 is far greater than the gain of $500.

Here are some of its key concepts:

  • Losses loom larger than gains which is referred to as loss aversion.
  • Gains and losses are dependent on frame of reference.
  • A result of this framework is that depending on the situation the same individual could be either risk-seeking or risk-averse.

Uncovering Concepts and Biases With Behavioral Finance

The study of behavioral finance will provide you better insight on the concepts and biases that affect your decisions when it comes to your debts, payments, risks and investments. With this, you can assess your situation more rationally so that you allocate your finances wisely.

The primary effects observed in behavioral finance are:

  • Anchoring Bias is the tendency to focus on a specific reference point in evaluating a situation or decision. As a component of prospect theory, anchoring can be responsible for risk-seeking and risk-averse strategies. Instead of evaluating a product based on its intrinsic value, an investor may only look at past investment performance rather than the current state of a product.
  • Emotions can cause individuals to make decisions based on feelings instead of facts. When people make decisions based on emotions, they have a higher likelihood of making poor decisions or decisions they may regret later, compared to decisions they are certain of making if they were thinking logically.
  • Herd Instinct is when people are influenced by the actions, beliefs and behaviors of others around them. Herd instinct can lead individuals to hasty decisions as they use the actions of others as a heuristic (a mental shortcut) for decision-making. For example, fear of missing out (FOMO) is a common example of individuals falling victim to herd behavior.
  • Hyperbolic Discounting is the way people inconsistently weigh future benefits. It leads to regret and less-than-optimal decision-making. For example, a person prefers $100 today over $105 tomorrow, but does not prefer $100 in 30 days over having $105 in 31 days. Despite the fact that there is a one-day difference in payoffs for each scenario, the reference point of the reward in time changes the preferences of the individual.
  • Mental Accounting is the way people mentally organize, evaluate and monitor their finances. A form of mental accounting is the practice of segregating gains and losses into different categories. Mental accounting can yield suboptimal decisions as investors are unable to see the large picture across these categories.
  • Overconfidence (or Self-Attribution) is the tendency of people to overestimate their knowledge, underestimate risk, and overestimate their control of situations. The problem with overconfidence is that it makes a person less cautious when making investment decisions. You might view your investments as less risky than they really are.
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LEARN HOW TO ADDRESS THESE COGNITIVE BIASES

Now that you know more about these cognitive biases and concepts, you can be aware of them in your day-to-day. Learn how to overcome them.

Examples of Common Behavioral Finance Effects and Biases In Action

A Proclivity to Hold Losing Stocks

Concept: Disposition Effect

Let’s say you buy a stock at $42 which then drops to $34 before rising to $39. Would you hold onto the stock in hopes of getting back to $42? Most people would. They would wait until it gets above $42, regardless of the underlying aspects of the company.

This anomaly is called the disposition effect, as coined by Hersh Shefrin and Meir Statman. The disposition effect is a combination of anchoring and mental accounting, wherein traders sell gaining stocks to realize their wins while they hold the losing stocks to avoid the emotional state of loss.

Surging Meme Stocks Indicates a Herd

Concept: Herd Instinct

In June 2021, the world saw a Meme Stock explosion. It happened when a subset of traders drove up Bed Bath & Beyond (BBY) shares by 62%. The phenomenon is an example of how herd behavior and overconfidence can affect the marker. Investors drove shares not because the company beat earnings but due to an increase in demand because of the fear of missing out (FOMO) on trends.

Confirming What We Want to Hear

Concept: Confirmation Bias

Have you ever seen an investor who cannot be swayed that their investment could perform poorly? Every bit of evidence seems to be ignored except for the pieces of information that support their position? This is an example of confirmation. In finance, confirmation bias can contribute to overconfidence in their decisions, investing or otherwise.

Paying Later Weakens Self-Control

Concept: Hyperbolic Discounting

Cash is a more immediate form of payment where the loss of money is felt by an individual as it leaves their wallet. On the other hand, using credit cards can disguise losses. People tend to not immediately feel the “pain of paying,” so it is possible to overvalue what happens in the present (hyperbolic discounting). Because of this, some people underestimate how much they are spending and end up with high debts. It’s a good idea to look into how credit cards work and to use it wisely.

“Deals” Use Anchoring to Create Sales

Concept: Anchoring Bias

Deals can play into the way people anchor prices and make decisions where they think they’re getting the best offer. Imagine you are buying auto insurance. As part of the purchase process, you are offered a coverage plan at $1,500. Your insurer gives you a safe driver discount of 10%. Now the total price comes out to be $1,350. You want to compare quotes with another car insurance provider. You find another insurance company, and your second insurer gives you the same offer of $1,350. Instead of a safe driver discount, you see, say, a charge for being a risky driver based on your driving history. By anchoring at the higher price of the risky driver, the first company creates a perception of an added benefit to create more sales.

This is an illustration of a person standing in the middle of a plank and is trying to balance making emotional-based or logical-based decisions.

How Behavioral Finance Differs From Traditional Finance Theory

Generally, there are two schools of thought when it comes to finance. The first one is behavioral finance. The second is traditional finance theory.

Traditional finance theory is the opposite of behavioral finance. It dismisses the idea that a person’s psychology can affect their financial decisions. It states that people act rationally and have unbiased expectations of the future. They base their investment decisions on data and information they have gathered or received.

  • Concept
    Traditional Finance Theory
    Behavioral Finance Theory
  • Decision-making

    Individuals are rational and
    capable of processing
    all pieces of information
    without bias when
    making financial and
    investment decisions.

    Individuals are irrational
    and have biases.
    Their emotions play
    a role in making financial
    and investment decisions.

  • Consistency

    Decisions are consistent
    and the behavior
    of the decision-maker is
    constant.

    Decisions are inconsistent.
    Various factors affect
    decisions.

  • Processing of Information

    People receive unlimited
    amounts of perfect data,
    information and knowledge.
    They make decisions
    after carefully processing
    the information properly.

    Individuals’ rationality is
    limited, according to Herbert
    Simon's "Bounded Rationality.”
    They cannot process
    all pieces of information.
    Therefore, they are bound
    to make an error
    in judgment even if the
    information is accurate.

  • Market Outlook

    The market is viewed
    as efficient. It
    represents the true
    value of the financial
    market.

    The market is seen
    as volatile. That
    is why market
    anomalies exist.

  • Risk

    Risk is objective
    and can be quantified.
    It can be calculated.

    Risk is subjective.
    The risk-taking level
    of each person
    varies and cannot be
    measured objectively.

  • Return

    Traditional finance theory
    sees the risk and return
    relationship to be linear.
    As the risk increases, so
    does the potential return.

    Since risk is personal
    and subjective, behavioral finance
    theory views the relationship
    of risk and return to be
    inconsistent based on several
    psychological biases and
    emotions.

  • Self-Control

    Investors have self-control.

    Investors’ self-control is not perfect.

How Behavioral Finance Can Help

Awareness of what behavioral finance is and how your psychology may affect finance and investment decision-making will help you become a more savvy investor and consumer. Knowing the biases that affect your decisions can help improve your financial capability. That is because you will be in a better position to make calculated moves when it comes to your money.

Take loss aversion for example. It is one of the most common cognitive biases. Because of this, you end up avoiding small risks even if they are probably going to give good returns. It is also among the reasons why some people choose saving over investment. Being aware of this bias will help you have a better view on wealth management. You can check up on your emotions and make a mental effort to take some risk by starting with assets that usually perform well.

Overcoming Bias

Behavioral finance awareness will allow you to overcome personal biases. This way, you can make better and well-informed financial decisions.

Here are some ways to do that:

  • This is an icon

    Overconfidence (or Self-Attribution)

    If it is your first time to invest, it is best to consult a professional. Find out what is the best investing strategy based on your goals. Ask for alternative perspectives as well. For instance, since you are a beginner, try passive investing first.

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    Anchoring Bias

    Do not make a decision without researching. Having enough data will allow you to make a comprehensive assessment of asset prices and reduce your anchoring bias. It is also important to always be open to new data even if you think they are not aligned with what you already know.

  • This is an icon

    Mental Accounting

    The problem with mental accounting is that you may fail to properly prioritize your expenses. To overcome this, you may want to start with a budget plan. Use it as a guide when making financial decisions. This way, you assess when it is best to save money and when to spend.

  • This is an icon

    Herd Instinct

    When it comes to investing, it is important to look at the fundamentals instead of going with what other people choose. Assess the company and make a decision based on the information you gather. Ask yourself if it seems like a solid investment or not. Do not easily get swayed by trends and what is promoted as hot stocks on the Internet.

  • This is an icon

    Hyperbolic Discounting

    Awareness is the first step in overcoming the need for immediate awards versus those that come later on. As much as possible, try to avoid situations that may trigger hyperbolic discounting. If you cannot do so, make sure you weigh the possible consequences of each option. Consider the future instead of only focusing on the present.

Behavioral Finance FAQs

Understanding behavioral finance can be a bit difficult, especially if it is your first time encountering this theory. MoneyGeek answers some frequently asked questions to help you.

Expert Insights

Behavioral finance can give you an idea of how consumers make purchase decisions. To help you better understand the concept, MoneyGeek asked industry leaders and academics to provide expert insight.

  1. What do you think is the most important thing individuals need to know about behavioral finance?
  2. Do you have any tips on how people can apply behavioral finance assessment when making financial and investment decisions?
Robert R. Johnson
Robert R. Johnson

Professor of Finance at Creighton University

Lynn Toomey
Lynn Toomey

Founder & RetireMentor Coach at Her Retirement

Margaret J. King
Margaret J. King

Cultural Analyst and Director at The Center for Cultural Studies & Analysis

Related Content

To help you better understand finance and how you can make better financial decisions, here are some MoneyGeek pages with related terms and concepts.

About the Author


expert-profile

Nathan Paulus is the director of content marketing at MoneyGeek. Nathan has been creating content for nearly 10 years and is particularly engaged in personal finance, investing, and property management. He holds a B.A. in English from the University of St. Thomas Houston.


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