Behavioural Economics is a field that rapidly grew, seeing two massive spikes of popularity in 2002 and 2017, when Nobels were awarded to Kahneman and Thaler respectively, two very famous behavioural economists. Although these men contributed a lot to behavioural economics, there is more to the field than the (wide range) of topics they have studied. As behavioural topics became more and more popular, and research became both deeper and wider, subfields of behavioural economics morphed into existence. One of these subfields is behavioural finance. This is what we will be looking into today.
What is Behavioural Finance? Behavioural finance proposes psychology-based theories to explain the behaviour of financial agents (investors, financial analysts etc.) and how their decisions can cause stock market anomalies, such as unexpectedly steep rises or falls in stock price. The purpose of behavioural finance is to identify and understand why people make certain financial choices.
Unsurprisingly, as a subfield, behavioural finance doesn't differ too much from behavioural economics. Within BE, the ideal of the homo economicus was assumed. Decision-making was rational, transitive, utility-maximising and selfish. BehFin also had a theoretical starting point: The efficient market hypothesis, from now on referred to as EMH. The EMH is yet another ideal. It proposes that at any given time in a market in which there are plentiful buyers and sellers, prices reflect all available information. This means that within this market, prices signal how much a stock is in demand and how much of the stock is being supplied. Especially the demand side ought to be a reflection of the "value and desirability" of owning the stock. This would be derived from all the information that would be freely available for you to find in markets that were transparent to the extent that you could find this out. However, behavioural finance wouldn't exist if many studies hadn't documented long-term historical phenomena that contradict the efficient market hypothesis and cannot be captured in models based on this ideal of the perfect investor. Many traditional models are based on the belief that market participants always act in a rational and wealth-maximizing manner as seen within behavioural economics. Starting from this ideal can severely limit a financial model's ability to make accurate or detailed predictions. Enter Behavioural Finance.
What does Behavioural Finance Teach? So Behavioural finance rejects rationality and the idea of the homo economicus. It also accepts dual-system reasoning, and the heuristics and biases that come with system 1, and its respective consequences. In this section we are going to dive into the main topics within this field. If you know plenty about behavioural economics, you should be aware of some of gthe main concepts with behavioural finance. Four main concepts within behavioural finance are notably:
Mental accounting refers to the propensity for people to allocate money for specific purposes. I have written multiple articles on mental accounting and will link them, so I won't have to go very into depth here.
Within mental accounting, there is the idea that people have a set idea of what certain sums of money should be used for (groceries, rent, clothes, savings, pension, investing etc.). Even when moving money around (you can, afterall money is fungible) people rarely do it. This has given rise to an interesting phenomenon, co-holding. In which people hold both credit card debt (expensive) and savings (doesn't yield much). Using one to pay off the other makes sense, but it's rarely ever done.
To examplify: in the UK, people have enough savings to pay down half the credit card debt amassed. That means banks would not be able to receive half the profit they make on credit card debt, which is billions. That is massive!
Herd behaviour states that people tend to mimic others. In this case people follow the financial behaviours of the majority (the herd). The herd refers to all the other investors around them. Herding is very common in the psychology literature. We are social animals and so we look to the social group to infer what we should be doing, or what we're doing is right. It assumes that someone else has more/better information than we do, and we should capitalize on that information. If you like a more in-depth review of herding, please read the article here.
Anchoring can refer to a plethora of phenomena in BE, but often it boils down to the individual focussing on an initial number. This is the reason sales work so well. If an item of clothing was initially $60 and is now marked down to $25, we still infer that the item has a quality that is worth $60, we just now only have to pay less than half for it, which is a great deal! Within behavioural finance, achoring mainly occurs on the stock price. People can increasingly focus on the highest price the stock has ever been at, and aim to sell for at least that value. More commonly, people anchor on the stock price they paid themselves. This anchor is used to calculate whether the development of the stock price is a loss or a gain. And this has given rise to the disposition effect: in which as soon as stocks make gains we sell them to secure our gain, but stocks that lose money we keep, to allow for the possibility of them going back to their initial level at least, so we don't have to sustain a loss necessarily. Often, the winning stocks could have made us more money if we had kept them, and the losing stocks just end up costing more, as they never quite do recover their initial level. We should have just cut our losses. But we don't.
Lastly, high self-rating, or just the over-confidence and self-serving bias, refer to the tendency of investors to rank themselves better than others or higher than the average person. This oddly goes completely against being a sheep, although I have met people who think they are better at being a sheep than others and are very proud of this quality. So who knows which odd shapes and forms these biases can take...
To examplify what these two biases might look like in the market: When an investment performs well, its investors might believe that they are the new investment guru on the block. It is of course due to their expertise, not a random market fluctuation (self-serving). No one else had quite the intel they did, or even if they did, couldn't have predicted it (over-confidence). When this investment performs poorly, suddenly it is the market's fault, a downturn, random flutucation (self-serving) and no one could have known this, not even the experts were aware (over-confidence).
These are of course not the only fields and topics of study within behavioural finance. This article by the Corporate Finance Institute has highlighted the 10 most common and most studied biases when it comes to behavioural finance. So make sure to give that a read as well!
What can we do with Behavioural Finance? So now that we know that behavioural finance teaches us that we are very flawed decision-makers, what should we do?
Well, it's probably better to be an active rather than a passive student (I have taught plenty of passive students, it's a waste of everyone's time...). Now that you know you are a flawed human-being (when it comes to financial decision-making), look at your finances again. Knowing the (many) biases that you have, what would you have done differently?
Even if you're not too sure about doing it yourself, why not go to an investment (consultancy) firm? Or a personal financial planner? If you are interested in improving your financial knowledge, wealth and health, go for it. If you wanted to improve your health you'd also go to a doctor right? So why not go to an expert for your finances?
Now it might seem that behavioural finance looks mainly at the stockmarket, but all the four phenomena mentioned earlier, can show up in day to day life as well, without ever mentioning the stock market. Also make sure to look at the way you spend and save your money. It will reveal a wealth of information about your decision-making. It's quite likely that you are applying some form of mental accounting, and that your purchasing pattern might be driven by herding. And especially for those who aren't saving: stop blaming the current economic situation (self-serving) and thinking it'll turn out alright in the end (over-confident). You can't cash in on your biases, you are responsible for your own finances. So stop being an ostrich and take responsibility!