Introduction to behavioural finance

An Introduction to Behavioral Finance

For decades, psychologists and sociologists have opposed traditional theories of finance and economics, arguing that humans are not rational actors who maximize utility and that markets are not effective in the real world. The field of behavioural economics was born in the late 1970s to solve these problems, accumulating a wide range of cases in which people consistently behave "irrationally". The application of behavioural economics to the world of finance is of course known as behavioural finance. From this point of view, it's not hard to imagine the stock market as a person: it has mood swings (and price swings) that can go from irritable to irritable in an instant. euphoria; he may overreact one day and make amends the next. But can human behaviour help us understand financial matters? Does market sentiment analysis provide us with practical strategies? Behavioural finance theorists suggest so.

Some findings from Behavioral Finance

Behavioural finance is a subfield of behavioural economics, which argues that financial decisions such as investing are not as rational as traditional financial theory predicts. For investors curious about how emotions and biases determine stock prices, behavioural finance offers some interesting descriptions and explanations.

The idea that psychology drives stock movements contrasts with established theories that support the idea that financial markets are efficient. Proponents of the Efficient Market Hypothesis (EMH), for example, argue that any new information relevant to value is quickly assessed by the market. Therefore, future price changes are random because all available information (public and some non-public) is already discounted to present values.

However, for anyone who weathered the dot-com bubble and the crash that followed, the effective market theory is hard enough to digest. Behaviourists explain that instead of being anomalies, irrational behaviours are commonplace. Researchers have regularly reproduced examples of irrational behaviour outside of finance using very simple experiments.

“It is underestimated to say that financial health affects mental and physical health and vice versa. It’s just a circular thing that happens, ”said Dr Carolyn McClanahan, Founder and Director of Financial Planning at Life Planning Partners Inc.“ When people are stressed about finances, they release chemicals called catecholamines. I think people have heard of things like adrenaline and things that set your whole body on fire. So it affects your mental health, it affects your ability to think. It affects your physical health, it makes you tired, it makes you tired, and you cannot sleep. And then once you can’t sleep you start having bad behaviours to deal with it.

Fear of Regret

Fear of Regret, or simply the theory of regret, deals with the emotional reaction people experience after realizing that they have made an error in judgment. When faced with the prospect of selling a stock, investors are emotionally affected by the price at which they bought the stock.3 They, therefore, avoid selling it to avoid regret for making a bad investment, as well as the embarrassment to report a loss of stock. We all hate to make mistakes, don’t we?

What investors should ask themselves when considering selling a stock is, “What are the consequences of repeating the same purchase if that stock was already liquidated and I would invest again?” If the answer is “no”, it’s time to sell; otherwise, the result is regret for buying a stock at a loss and regret for not selling when it became apparent that a bad investment decision was made, resulting in a vicious cycle in which avoiding regrets leads to more regrets.

The regret theory can also be applied to investors when they discover that a stock they had only considered buying has increased in value. Some investors avoid this regret by following conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision so that “everyone is.”

Oddly enough, many people feel much less embarrassed about losing money on a popular stock owned by half the world than they are about losing money on an unknown or unpopular stock.

Investors overconfidence

People generally consider themselves to be above average in their abilities. They also overestimate the accuracy and veracity of their knowledge, as well as the perceived superiority of their knowledge over others.

Many investors think they can synchronize the market at any time, but there is an overwhelming amount of evidence to the contrary. Excessive trust leads to excessive trading, with trading costs affecting profits.

Over-reaction and under-reaction

Investors become bullish when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during a downturn. A consequence of pegging or over-emphasizing recent events while ignoring historical data is an over or under-reaction to market events, which results in excessive price declines with bad news and an over-reaction. excessive rise with the good news.

At the height of optimism, investor greed moves stocks beyond their intrinsic value. When did it become a rational decision to invest in stocks with zero earnings and therefore an infinite price/earnings (P / E) ratio (think of the dot-com era, around the year 2000)? conditions can lead to panic and stock market crashes.

Social Factors

While much of behavioural economics to date has been guided by cognitive psychology, recent research in economic sociology indicates that there are also supra-individual forces at work in the behaviour of individuals. investors. A recent study, for example, found that individuals become much more cautious when making investment decisions on behalf of other close people, with people taking about a third less risk in a child’s wallet than they do. the one assigned to their account. Additionally, investors have become even more conservative by investing in accounts with culturally relevant labels like “retirement” or “college savings”.

Other research now examines how social relationships and even larger structures such as culture play into financial decisions. This shows that investor behaviour is determined not only by psychology but also by social factors.

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