Behavioral Finance - is descriptive of how investors behave. It assumes investors have cognitive limits and emotional biases.
Tradtional finance is normative, describing what investors should do,
Tradtional finance is normative, describing what investors should do,
- Behavioral finance, drawing on psychology, observes behaviors in an attempt to understand and explain how investors and markets behave.
- Traditional finance assumes that investors are rational: Investors are risk-averse, self-interested utility-maximizers who process available information in an unbiased way.
- Traditional finance assumes that investors construct and hold optimal portfolios; optimal portfolios are mean–variance efficient.
- Traditional finance hypothesizes that markets are efficient: Market prices incorporate and reflect all available and relevant information.
- Behavioral finance makes different (non-normative) assumptions about investor and market behaviors.
- Behavioral finance attempts to understand and explain observed investor and market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance.
- Behavioral biases potentially affect the behaviors and decisions of financial market participants. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and as a result improve upon economic outcomes. These biases may be categorized as either cognitive errors or emotional biases
The behavioral biases of individuals
Emotional Biases are caused by individuals' psychological predispositions. Emotional bias in not deliberate; it is more of a spontaneous reaction and it is more difficult to overcome
Cognitive errors are the result of mechanical or physical limitations; they result from the inability to analyze all information or from basing decisions on incomplete information. Cognitive errors are easier to overcome than emotional biases and respond to education
Psychological biases that can affect investment decisions. Key ones are
1. Anchoring bias is the tendency to give disproportionate weight to the first information received or first number envisioned, which is then adjusted.
2. Status quo bias reflects the tendency for forecasts to perpetuate recent observations—that is, to avoid making changes and preserve the status quo, and/or to accept a default option.
3. Confirmation bias is the tendency to seek and overweight evidence or information that confirms one’s existing or preferred beliefs and to discount evidence that contradicts those belief
To mitigate - seek out contrary information adn alternate methods of analysis
4. Overconfidence bias is unwarranted confidence in one’s own intuitive reasoning, judgment, knowledge, and/or ability. This bias may lead an analyst to overestimate the accuracy of her forecasts and/or fail to consider a sufficiently broad range of possible outcomes or scenarios.
5. Prudence bias reflects the tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.
6. Availability bias is the tendency to be overly influenced by events that have left a strong impression and/or for which it is easy to recall an example.
Behavioral Finance Classics -
Emotional Biases are caused by individuals' psychological predispositions. Emotional bias in not deliberate; it is more of a spontaneous reaction and it is more difficult to overcome
Cognitive errors are the result of mechanical or physical limitations; they result from the inability to analyze all information or from basing decisions on incomplete information. Cognitive errors are easier to overcome than emotional biases and respond to education
Psychological biases that can affect investment decisions. Key ones are
1. Anchoring bias is the tendency to give disproportionate weight to the first information received or first number envisioned, which is then adjusted.
2. Status quo bias reflects the tendency for forecasts to perpetuate recent observations—that is, to avoid making changes and preserve the status quo, and/or to accept a default option.
3. Confirmation bias is the tendency to seek and overweight evidence or information that confirms one’s existing or preferred beliefs and to discount evidence that contradicts those belief
To mitigate - seek out contrary information adn alternate methods of analysis
4. Overconfidence bias is unwarranted confidence in one’s own intuitive reasoning, judgment, knowledge, and/or ability. This bias may lead an analyst to overestimate the accuracy of her forecasts and/or fail to consider a sufficiently broad range of possible outcomes or scenarios.
5. Prudence bias reflects the tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.
6. Availability bias is the tendency to be overly influenced by events that have left a strong impression and/or for which it is easy to recall an example.
Behavioral Finance Classics -
1. Barber, Brad M., and Terrance Odean. 2001. “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” Quarterly Journal of Economics, vol. 116, no. 1:261–292.
Summary
2. Kahneman, Daniel, and Amos Tversky. 1979. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica: Journal of the Econometric Society, vol. 47, no. 2:263–291.
Summary
Summary
2. Kahneman, Daniel, and Amos Tversky. 1979. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica: Journal of the Econometric Society, vol. 47, no. 2:263–291.
Summary