Behavioral Finance

7 Key excerpts on "Behavioral Finance"

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  eBook - ePub

  Lecture Notes in Behavioral Finance

  • Itzhak Venezia(Author)
  • 2018(Publication Date)
  • WSPC

    (Publisher)

  Behavioral Finance is the fastest growing area in academic research in finance. It started its meteoric rise circa the mid-1980s and it is by now an important part of finance in investments and in corporate finance. Finance is a dynamic area and it has developed many sub-areas over time either because of new theoretical findings, market developments and legislation. For example, the market for options grew in the 1970s, in part, because of the theoretical advances in the pricing of options. Likewise, the area of Behavioral Finance was developed as a reaction to theoretical findings in psychology and to evidence from financial markets that did not sit well with market efficiency. These findings prompted the fusion of insights from the two distinct fields to create Behavioral Finance. The new area, as we shall see during this course, contributes considerably to the understanding of the behavior of capital markets and capital markets participants. Behavioral Finance has many applications that help individuals, corporations, analysts, professional investors and legislators to make better financial decisions and to improve the functioning of capital markets.

  Since Behavioral Finance explores biases, it may seem that it mainly points at activities that decision makers need to avoid. However, revealing the cognitive biases of decision makers and becoming aware of flaws in their judgments, allows us to find ways to overcome these biases and to design policies to improve financial decision making and the functioning of capital markets. Authors such as Ariely (2008, 2010), Kahneman (2011), and Thaler and Sunstein (2009), popularized Behavioral Finance by making the concepts of this area more accessible to academics, analysts, professional investors and laypeople.

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  Behavioral Finance and Wealth Management

  How to Build Optimal Portfolios That Account for Investor Biases

  • Michael M. Pompian(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  PART One

  Introduction to the Practical Application of Behavioral Finance

  Passage contains an image

  CHAPTER 1

  What Is Behavioral Finance?

  People in standard finance are rational. People in Behavioral Finance are normal.

  —Meir Statman, Ph.D., Santa Clara University        

  To those for whom the role of psychology in finance is self-evident, both as an influence on securities markets fluctuations and as a force guiding individual investors, it is hard to believe that there is actually a debate about the relevance of Behavioral Finance. Yet many academics and practitioners, residing in the “standard finance” camp, are not convinced that the effects of human emotions and cognitive errors on financial decisions merit a unique category of study. Behavioral Finance adherents, however, are 100 percent convinced that an awareness of pertinent psychological biases is crucial to finding success in the investment arena and that such biases warrant rigorous study.

  This chapter begins with a review of the prominent researchers in the field of Behavioral Finance, all of whom support the notion of a distinct Behavioral Finance discipline, and then reviews the key drivers of the debate between standard finance and Behavioral Finance. By doing so, a common understanding can be established regarding what is meant by Behavioral Finance, which leads to an understanding of the use of this term as it applies directly to the practice of wealth management. This chapter finishes with a summary of the role of Behavioral Finance in dealing with private clients and how the practical application of Behavioral Finance can enhance an advisory relationship.

  Behavioral Finance: THE BIG PICTURE

  Behavioral Finance, commonly defined as the application of psychology to finance, has become a very hot topic, generating new credence with the rupture of the tech-stock bubble in March of 2000. While the term Behavioral Finance

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  Behavioral Finance and Wealth Management

  How to Build Investment Strategies That Account for Investor Biases

  • Michael M. Pompian(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  At its core, Behavioral Finance attempts to understand and explain actual investor and market behaviors versus theories of investor behavior. This idea differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. Wealth managers from around the world who want to better serve their clients have begun to realize that they cannot rely solely on theories or mathematical models to explain individual investor and market behavior. As Meir Statman's quote puts it, standard finance people are modeled as “rational,” whereas Behavioral Finance people are modeled as “normal.” This can be interpreted to mean that “normal” people may behave irrationally—but the reality is that almost no one (actually, I will go so far as to say absolutely no one) behaves perfectly rationally, and dealing with normal people is what this book is all about. We will delve into the topic of the irrational behaviors of markets at times; however, the focus of the book is on individual investor behavior.

  Fundamentally, Behavioral Finance is about understanding how people make financial decisions, both individually and collectively. By understanding how investors and markets behave, it may be possible to modify or adapt to these behaviors in order to improve financial outcomes. In many instances, knowledge of and integration of Behavioral Finance may lead to better than expected results for both advisors and their clients. But advisors cannot view Behavioral Finance as a panacea or “the answer” to problems with clients. Working with clients is as much an art as it is a science. Behavioral Finance can add many arrows to the art quiver.

  We will begin this chapter with a review of the prominent researchers in the field of Behavioral Finance, all of whom promote a deeper understanding of the benefits of the Behavioral Finance discipline. We will then review the key differences debate between standard finance and Behavioral Finance. By doing so, we can establish a common understanding of what we mean when we say Behavioral Finance, which will in turn permit us to understand the use of this term as it applies directly to the practice of wealth management. This chapter will finish with a summary of the role of Behavioral Finance in dealing with private clients and how the practical application of Behavioral Finance can enhance an advisory relationship.

  Behavioral Finance: THE BIG PICTURE

  Behavioral Finance, commonly defined as the application of psychology to finance, has become a very hot topic, generating credence with the rupture of the tech-stock bubble in March of 2000, and has been pushed to the forefront of both investors’ and advisors’ minds with the financial market meltdown of 2008–2009. While the term Behavioral Finance is bandied about in books, magazine articles, and investment papers, many people lack a firm understanding of the concepts behind Behavioral Finance. Additional confusion may arise from a proliferation of topics resembling Behavioral Finance, at least in name, including: behavioral science, investor psychology, cognitive psychology, behavioral economics, experimental economics, and cognitive science, to name a few. Furthermore, many investor psychology books that have entered the market recently refer to various aspects of Behavioral Finance but fail to fully define it. This section will try to communicate a more detailed understanding of the term Behavioral Finance.

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  Behavioral Finance and Investor Types

  Managing Behavior to Make Better Investment Decisions

  • Michael M. Pompian(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Many economic decisions are made in the absence of perfect information. For instance, some economic theories assume that people adjust their buying habits based on the Federal Reserve's monetary policy. Naturally, some people know exactly where to find the Fed data, how to interpret it, and how to apply it; but many people don't know or care who or what the Federal Reserve is. Considering that this inefficiency affects millions of people, the idea that all financial actors possess perfect information becomes implausible.

  Again, as with market efficiency, human rationality rarely manifests in black or white absolutes. It is better modeled across a spectrum of gray. People are neither perfectly rational nor perfectly irrational; they possess diverse combinations of rational and irrational characteristics, and benefit from different degrees of enlightenment with respect to different issues.

  THE ROLE OF Behavioral Finance WITH PRIVATE CLIENTS

  Private clients can greatly benefit from the application of Behavioral Finance to their unique situations. Because Behavioral Finance is a relatively new concept in application to individual investors, investment advisors may feel reluctant to accept its validity. Moreover, advisors may not feel comfortable asking their clients psychological or behavioral questions to ascertain biases, especially at the beginning of the advisory relationship.

  One of the objectives of this book is to position Behavioral Finance as a more mainstream aspect of the wealth management relationship, for both advisors and clients.

  As practitioners increasingly adopt Behavioral Finance, clients will begin to see the benefits. There is no doubt that an understanding of how investor psychology impacts investment outcomes will generate insights that benefit the advisory relationship. The key result of a Behavioral Finance–enhanced relationship will be a portfolio to which the advisor can comfortably adhere while fulfilling the client's long-term goals. This result has obvious advantages—advantages that suggest that Behavioral Finance will continue to play an increasing role in portfolio structure.

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  Behavioral Finance and Your Portfolio

  A Navigation Guide for Building Wealth

  • Michael M. Pompian(Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Each of the two subtopics of Behavioral Finance corresponds to a distinct set of issues within the standard finance versus Behavioral Finance discussion. With regard to BFMA, the debate asks: Are markets “efficient,” or are they subject to behavioral effects? With regard to BFMI, the debate asks: Are individual investors perfectly rational, or can cognitive and emotional errors impact their financial decisions? These questions are examined in the next section of this chapter; but to set the stage for the discussion, it is critical to understand that much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. In academic studies, researchers have documented abundant evidence of irrational behavior and repeated errors in judgment by adult human subjects.

  Finally, one last thought before moving on. It should be noted that there is an entire body of information available on what the popular press has termed the psychology of money. This subject involves individuals' relationship with money—how they spend it, how they feel about it, and how they use it. There are many useful books in this area; however, this book will not focus on these topics, it will focus on building better portfolios.

  Standard Finance versus Behavioral Finance

  This section reviews two basic concepts in standard finance that Behavioral Finance disputes: rational markets and the rational economic man. It also covers the basis on which Behavioral Finance proponents challenge each tenet and discusses some evidence that has emerged in favor of the behavioral approach.

  Overview

  On Monday, October 18, 2004, a significant but mostly unnoticed article appeared in the Wall Street Journal. Eugene Fama, one of the leading scholars of the efficient market school of financial thought, was cited admitting that stock prices could become “somewhat irrational.”8 Imagine a renowned and rabid Boston Red Sox fan proposing that Fenway Park be renamed Mariano Rivera Stadium (after the outstanding New York Yankees pitcher), and you may begin to grasp the gravity of Fama's concession. The development raised eyebrows and pleased many behavioralists. (Fama's paper “Market Efficiency, Long-Term Returns, and Behavioral Finance” noting this concession at the Social Science Research Network is one of the most popular investment downloads on the web site.) The Journal article also featured remarks by Roger Ibbotson, founder of Ibbotson Associates: “There is a shift taking place,” Ibbotson observed. “People are recognizing that markets are less efficient than we thought.”9

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  Understanding Financial Crises

  • Ensar Yılmaz(Author)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  Mainstream economic theory primarily presumes three features of the human way of thinking, which are: “unbounded rationality”, “unbounded willpower”, and “unbounded selfishness”. However, it is widely recognized that these are not realistic. Behavioral economics constrains this unboundedness and ties it to reasonable boundaries of realism. This makes the behavioral perspective crucial to understanding the mechanisms behind financial crises, in addition to the functioning of economies in normal times.

  In this sense, a psychological perspective can be used to complement the perspectives provided by economics. For this, three subjects may be listed. First, cognitive biases are pervasive and important in human behavior in a general sense, and in economics in particular. Second, cognitive biases can be mitigated by various cognitive or structural tools. Third, economic behavior is not only concerned with individual behavior but it occurs in a collective environment, such as herd behavior.

  Policy implications of behavioral economies are valuable, especially in order to guide decentralized interactions among actors in any economy, which has the potential to lead to financial disruptions. Hence we have to mention that there should be an external constraint that will limit markets whose main concern is not to optimize social welfare. Markets can contain imperfections, inefficiencies, and psychological biases of their agents, such as greed, herd behavior, fear, ignorance, competition among people (jealousy), and many other biases mentioned above. Understanding them can help us to construct more resilient economic structures. However, if we reduce the reasons for crises to just behavioral biases, we cannot understand the other structural mechanisms playing critical roles in the development of crises that are discussed in the different chapters of this book. We have to think in a more holistic manner.

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  Nonprofit Investment and Development Solutions

  A Guide to Thriving in Today's Economy

  • Roger Matloff, Joy Hunter Chaillou(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  The concept of money is actually far more complex than most realize. Ask almost anyone why a hundred dollar bill, which is after all just a piece of paper, has value and they could not explain it to you. Yet, having money in your pocket and in your bank account is a satisfying experience, just as scrimping your way through the day only to return home to an ocean of debt is a destructive one.

  More often than not, it's not about having enough to eat, or clothes on our back—it's about money itself. And so it should come as no surprise that our behavior concerning money and investments has deeply rooted motivations, many of them concealed from our conscious thoughts, nor should it be surprising that when it comes to money we lie to ourselves—a lot.

  Behavioral Factors and Investing

  Financial decision-making is to a degree the result of rational thought and knowledge, but it is also the consequence of values, emotions, and bias. Though their effects are not fully understood, the stock market is known often to reflect the buying and selling patterns of a mass market driven by individual psychological forces. In fact, a fair degree of market volatility is considered to be the consequence of people behaving a certain way just because that's what others are doing, or because they are following a fad. The spread of certain mass behavior toward the market, either buying or selling, has been compared to that of the spread of an epidemic.

  Investors generally believe they act independently of emotional and psychological impulses. They consider themselves to be rational and objective when it comes to making investment decisions. They tell themselves, and others, that they analyze key factors, obtain pertinent information, and then make calculated decisions designed to optimize their investment income.

  To a certain extent this is very often true. What they do not acknowledge, though, is the role human psychology—our essential personality—plays in making many of the choices that lead to the final decision. For example, many years ago the investor may have had an unpleasant encounter with a broker at one of the major investment banking institutions. Never mind that the firm offers superior resources and advice, the investor never accesses any of their information, shutting him or her off from valuable insight.

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