This article will discuss behavioral finance and define some of the most common behavioral traits that researchers have identified. We will then examine ways in which investors can mitigate the effects of behavioral biases before concluding with a discussion of some biases that might be particularly prevalent among local agency investors. After reading this article, investors should have a better understanding of behavioral finance, and armed with this knowledge, be better prepared to manage their portfolio in an optimal manner.
Defining behavioral finance
Behavioral finance was founded in the late 1960s in response to traditional finance and its belief in efficient markets and rational investors. Behavioral finance is based upon the fact that financial market prices are a manifestation of millions of unique decisions made by thousands of different individuals. These individuals are subject to emotional traits and biases that often result in less than optimally efficient investment decisions. Proponents of behavioral finance have been encouraged by seemingly irrational market events such as the stock market crash of October 1987, the technology stock bubble of the late 1990s, and the financial crisis of 2008.
As might be expected, some traditional finance theorists are critical of behavioral finance. Some argue that even if markets appear to behave irrationally in the short-term, in the long run, markets return to an efficient state. Others believe that even seemingly irrational behavior such as bidding stocks up to unsustainable prices is effectively a rational response to expectations that other investors will bid prices even higher in the future. However, despite these criticisms behavioral finance has been increasing in popularity and many experts agree that investors can benefit from an awareness of behavioral traits and methods for mitigating their effects.
Common behavioral finance traits
Anchoring occurs in situations where investors do not fully incorporate new information into their analysis. Instead, an investor's opinion is "anchored" to their original forecast. New information may alter the forecast, but not to the degree that it would if investors were entirely unbiased.
Myopic loss aversion occurs when investors become too cautious due to an overemphasis on short-term performance. This can cause investors to reject investment strategies that promise attractive risk-adjusted long-term returns. This can occur even if the investment portfolio is designed to meet long-term objectives and can withstand principal fluctuations in the interim.
Confirmation bias is present when investors actively seek out information that reinforces their existing opinion. Financial markets are constantly in flux, and investors can benefit from examining the variety of opinions available in the marketplace. This type of critical thinking is far more beneficial than seeking out information that corroborates what the investor already believes.
Herd behavior occurs when investors are afraid of missing the latest investment trend or fad. Herd behavior is at the root of nearly every market bubble that has ever occurred. A recent example was when many individuals purchased overvalued technology stocks in the late 1990s because they were afraid of missing out on the gains that their fellow investors appeared to be enjoying. While some individuals do profit from this sort of investing, it requires nearly perfect timing in order to be successful over the long run.
Many investors, especially professionals, fall prey to the overconfidence bias. Simply stated, overconfidence refers to situations in which investors place more faith in their ability than their track record justifies. Overconfidence can lead to excessive risk-taking, overly active trading, or a lack of proper diversification. Many studies have shown that male investors are more prone to the overconfidence bias than female investors.
Prospect theory refers to the concept that investors view gains and losses differently. In other words, the satisfaction that investors receive when they make money does not equal the unhappiness that they feel when they lose money. Prospect theory often manifests in a tendency for investors to sell their winners too soon and hold onto their losers too long.
