What is Behavioral Finance? 

 

Why, and under what circumstance, can markets behave inefficiently? That is the central question of behavioural finance, which is the study of how psychological, cognitive and emotional factors impact market participants.[1] Behavioural finance is studied under the wider spectrum of behavioural economics, which looks at the psychological and social factors influencing economic decisions of individuals, businesses and societies at large.

The field of behavioural finance has received more attention in recent years, as theorists attempt to explain how and why investors and institutions make bad investment decisions. The traditional theory of finance, which assumes that economic agents are rational and efficient, failed to adequately explain why and how market participants made mistakes. Without understanding why bad choices are made, it’s difficult to come up with solutions to avoid making them.

Commenting on the traditional theory of finance, Barberis and Thaler (2003) note that, “after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns, and individual trading behavior are not easily understood under this framework.”[2]

Rather than assume that market participants are always rational and efficient, behavioural finance suggests that investors are subject to behavioural biases that make their investment decisions less than completely rational. These behavioural biases include overconfidence, representativeness, conservatism, availability bias, frame dependence, mental accounting, regret aversion and many others.[3]

A second crucial aspect of behavioural finance relates to understanding how investors misprice financial assets. While traditional theories of finance contend that rational investors will always correct the mispricing of securities by irrational investors, behavioural finance argues that, due to the limits to arbitrage, prices may remain unbalanced for a longer period of time. In finance, arbitrage entails the buying and selling of an asset in order to profit from the difference in price.[4] For behavioural finance theorists, arbitrage is limited because it is much more risky and costly than traditional theories assume.

Behavioural finance also looks at the role of heuristics in financial decision-making, which once again goes against the grain of traditional theories. Investors’ reliance on the affect, availability and similarity heuristics can almost always lead to systemic biases.[5] These approximate rules of thumb make it virtually impossible for market participants to act rationally and efficiently all the time.

The theory of behavioural finance has many prevalent themes and discourses that weren’t touched upon in this short introduction. Behavioural finance theorists are mainly interested in understanding how themes related to heuristics, anecdotes and stereotypes, and market inefficiencies contribute to non-rational decision-making.

Although most investors consider themselves to be rational agents, behavioural finance makes several striking observations about human nature and our decision-making faculties. The boom-and-bust nature of the global financial markets and the resulting Great Recession of the 2007-2009 period warrant a closer examination of behavioural theories in the future. However, these observations shouldn’t complicate an investor’s trading strategy or make them second-guess every decision they make. Rather, investors should understand the factors that make them tick and, to the extent possible, control how their biases influence their investment decisions.

[1] Martin Sewell (2010). Behavioural Finance. Behaviouralfinance.net.

[2] Alistair Byrne and Mike Brooks. Behavioral Finance: Theories and Evidence. The Research Foundation of CFA Institute Literature Review.

[3] Alistair Byrne and Mike Brooks. Behavioral Finance: Theories and Evidence. The Research Foundation of CFA Institute Literature Review.

[4] Investopedia. Arbitrage Definition. 

[5] Martin Sewell (2010). Behavioural Finance. Behaviouralfinance.net.

 

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