Effects of Behavioral Finance on Your Investments
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
Adviser technologies are increasingly making use of research in the field of behavioral finance. Companies are aiming to be more efficient when it comes to putting their clients on the path of investment planning in an efficient manner, and more importantly, helping them stay on that path.
Why is behavioral finance necessary?
When using the labels “conventional” or “modern” to describe finance, we are talking about the type of finance that is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These theories assume that people, for the most part, behave rationally and predictably.
For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational financial theories did a respectable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn’t be explained by theories available at the time. While these theories could explain certain “idealized” events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.
Behavioral Finance Helps Take Better Decisions
According to United Capital CEO Joe Durand, his company has already included the use of behavioral finance to help their clients make more informed and more efficient decisions. United Capital currently manages over US$ 18.7 billion in assets. A large number of tools usually work by investigating the risk tolerance of clients and if they can remain vulnerable to general psychological bias. This comprises their ability to be convinced to spend either more funds or finding out if they feel more confident about their finances. Analysts and advisers are taking help from these tools in order to cultivate a more positive relationship between their firm and its clients.
Companies Want to Learn More about Their Clients
United Capital had already initiated into marketing for their technology platform aimed at advisers. These tools can help advisers probe their clients the right way and gain more relevant and important views that the clients hold about money and the foundation of reasoning behind their current goals. FinLife Partners, one of the tools, has been used by advisers to deepen their relationship with their clients and has shown a stronger growth in revenue for them.
Duran added that one of the key difficulties for any adviser is finding out what can be actually good for clients and the reasons why advisers and clients can often be in disagreement. This is something that behavioral finance tools are trying to solve.
The behaviorists have yet to come up with a coherent model that actually predicts the future rather than merely explains, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn’t tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.
Behavioral finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.
Behavioral Biases can be divided into two primary categories: Cognitive Biases and Emotional Biases.
Cognitive Biases – These are a result of incomplete information or the inability to analyze and synthesize information correctly. Cognitive biases are generally easier to overcome through adequate education and training. A common form of cognitive bias is the Gambler’s Fallacy.
Emotional Biases – These are a result of spontaneous reactions that affect how individuals see information. Emotional biases are deeply ingrained in the psychology of investors and are generally much harder to overcome. Some common types of emotional biases include:
• Endowment Bias – The tendency to overvalue an asset which an investor already holds. Put simply, investors tend to attach more value to the assets they own rather than the ones they don’t. This bias results in investors holding on to an asset for too long and possibly losing money in the process.
• Break-Even Effect – This suggests that investors who have lost money often jump at the chance to make up their losses. The urge to break-even can induce the loss making investor to take bets which they otherwise wouldn’t have taken.
Some concepts of Behavioral Finance are-
• The concept of Anchoring draws upon the tendency for us to attach or “anchor” our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
• Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money’s source and intent.
• Seeing is not necessarily believing, as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to be more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
• The Gambler’s Fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
• Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
• Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
• Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
• Prospect theory refers to an idea that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
By Nishad MUKHERJI