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It would be nice if investors and markets moved solely on the basis of fundamentals and economic and financial analysis of businesses. But at times, investors appear to lack self-control, act irrational, and make decisions based more on personal biases than facts.

The study of such psychological influences on investors and, by extension, markets, is called behavioral finance.

What Is Behavioral Finance?

You could say behavioral finance came about as a way to explain in a rational way the irrational behavior of markets and investors or, as one acclaimed economist put it, finance from a broader social science perspective including psychology and sociology.

Traditional financial theory holds that markets and investors are rational; investors have perfect self-control, and aren't confused by cognitive errors or information processing errors.

Now, according to the Corporate Finance Institute, behavioral finance holds that investors are considered "normal," not "rational;" they have limits to their self-control, are influenced by their own biases, and make cognitive errors that can lead to wrong decisions.

The study of behavioral finance, a sub-field of behavioral economics, arose in the 1980s, when cracks began to appear in what was then considered the Efficient Market Hypothesis.

Efficient Market Hypothesis

The Efficient Market Hypothesis, or EMH, was an investment theory that held that share prices reflect all information about a particular investment or market at all times, so investors can't purchase undervalued stocks or sell stocks for inflated prices. Risk-adjusted excess returns, called alpha, cannot be consistent in EMH, meaning only inside information can result in outsize risk-adjusted returns.

But if EMH were fact, it would be impossible to outperform the overall market even with expert stock-picking or market timing. The only way an investor could "beat the market" would be by purchasing riskier investments. Because of this, those with faith in EMH say there is no merit in searching for undervalued stocks or trying to predict market trends through either fundamental or technical analysis.

And investors like Warren Buffett have defied EMH by consistently "beating the market," or having better returns, over long periods of time - which would be impossible.

As evidence that stock prices can deviate from their fair values, critics of EMH point to events like the 1987 stock market crash, when the Dow Jones Industrial Average lost more than 20% in a single day.

Economist and Yale academician Robert J. Shiller, who won the 2013 Nobel Memorial Prize in Economic Sciences, explained in a paper published in the Journal of Economic Perspectives in 2003 titled From Efficient Markets Theory to Behavioral Finance that "Academic finance has evolved a long way from the days when efficient markets theory was widely considered to be proved beyond doubt."

The heyday of EMH was the 1970s, Shiller noted.

In the 1970s some "anomalies," like slight serial dependencies in stock market returns, began to appear as cracks in the hypothesis of efficient markets.

He also noted that faith in EMH was eroded by "a succession of discoveries of anomalies, many in the 1980s," and, particularly, evidence of excess volatility of returns.

But it was in the 1980s that the "anomaly represented by the notion of excess volatility" started causing deep rifts in adherence to the theory, greater even than the so-called "January effect," or the "day of the week effect."

"The evidence regarding excess volatility seems...to imply that changes in prices occur for no fundamental reason at all, that they occur because of 'sunspots' or 'animal spirits' or just mass psychology," Shiller wrote.

Thus, in the 1990s, research on behavioral finance was born.

"Indeed," wrote Shiller, "we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information."

Shiller, writing after the so-called dot-com boom and subsequent bust, noted that the speculative bubble "had its origins in human foibles and arbitrary feedback relations and must have generated a real and substantial misallocation of resources."

Behavioral Finance Concepts

There are four main key concepts to behavioral finance.

  • Mental accounting -- the propensity to allocate money for specific purposes
  • Herd behavior -- the habit of people to imitate the financial behavior of a majority
  • Anchoring -- the attachment of a spending level to an easy reference, like spending more money for a popular brand of anything.
  • High self-rating -- the tendency of individuals to rank themselves higher than an average individual.

Behavioral Finance Examples

Here are a couple of examples to behavioral finance in action.

  1. A lawsuit is brought against a company. Investors know from past experience with the company that news of the lawsuit is likely to make the company's share price fall. Many investors sell their holdings of the company, causing a further decline in the asset's value. Next, investors in other companies in the same industry fear lawsuits, knowing that a lawsuit has been brought against a similar company. Those investors sell their holdings. The prices of shares in other companies in the same industry then also fall. But none of the companies have taken any action or had a judgment against them. There has been no tangible reason for the price of the stock to fall.
  1. Another example of 'herd behavior' is Google (GOOG - Get Report) . Some investors, unaware of their own biases, may prefer to invest in an alphabetical order, like choosing a contractor based on "AAA" in the phone listing. There is a reason, for instance, that Apple Inc.'s (AAPL - Get Report)  stock ticker is AAPL. And what of Google? Google changed its name to Alphabet in 2015, being the "umbrella" under which Google operates.

Why Is Behavioral Finance Important?

Being aware of the precepts of behavioral finance can help investors check their perceptions against facts. A classic example is anchoring. This is when an investor 'anchors' on the price level of a previous portfolio value, and constantly compares the previous, often higher, value to the current value, without taking into account changes in the market or even outlook.

An investor may also anchor on the price paid for a particular security, and refuse to sell it despite poor performance, hoping to at least break even rather than suffer a loss without carefully assessing the reasons behind its loss of value.

Herding is another behavior to be aware of and try to avoid in your own investing. Herding is demonstrated exactly in the same way you would think - following the crowd. This is how less sophisticated investors often get into trouble. If "everyone" is buying a particular security, without looking into why, other than the fact its price is rising (because people are buying into it), often investors jump in not wanting to be left out of a good thing. This is exactly how market and securities "bubbles" form. Herding can cause an investor to buy into investments that may not be appropriate for their financial goals or risk tolerance.

The reverse is also true. When, for example, a stock market index starts to fall, often investors want to liquidate their holdings even in mutual funds to avoid losses. But a savvy investor can tell that, often, individual securities and markets rise until those who want to buy in do, and they fall when a few large investors sell. The reasons behind the movement need to be examined before following the 'herd,' namely, any information available about the company or market other than "it's going up," or "it's going down." Frequently, savvy and large investors sell after a rally to take profits.

High self-rating can also be considered overconfidence. This behavior often gets investors into trouble as well, because it is founded in the belief that you are smarter or more capable than you actually are, for instance at spotting the next 'hot' stock or investment trend. An overconfident investor is often seen trading more frequently than others, believing themselves to have better information than others. Frequent trading often leads to sub-par portfolio performance, caused by an increase in commissions, taxes and losses. 

So, you see, being aware of behavioral investing, your own and others, can help you save money and look more carefully before leaping into a move.

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