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Overview of Behavioral Finance

| | Posted in: Animal Spirits

Behavioral finance encompasses research on how investors fall short of a rational ideal in decision-making, and how markets are thereby somewhat inefficient. In his August 2014 paper entitled “Behavioral Finance”, David Hirshleifer examines sources of investor biases and provides an overview of research tying these biases to research on how they affect trading and market prices. Based on theory and the body of behavioral finance research, he concludes that:

  • Evidence of psychological biases persists in financial markets because markets are too complex, dynamic and stochastic for rational investors to dominate.
  • Three traits explain most of the psychological biases observed in markets.
    • Overconfidence, leading to self-deception.
    • Limited attention/cognitive processing, leading to reliance on heuristics (rules-of-thumb).
    • Feelings (emotional reactions).
  • Overconfidence is strong and tends to be stronger when complexity and uncertainty make decisions difficult. Self-enhancing attribution bias sustains overconfidence and promotes escalation of commitment even in the face of contrary evidence (sunk-cost effect).
    • Overconfidence stimulates aggressive trading and suppresses diversification.
    • Overconfidence drives overreaction to new information, and subsequent reversion.
  • Limited attention and processing power make people simplify their decision processes by:
    • Amplifying the salient (attention-grabbing)/easy-to-process and neglecting the non-salient (subtle).
    • Framing decisions in near isolation rather than in broad context.
  • Feelings trigger quick, intuitive assessments that can overwhelm rational analysis.
    • When fearful (happy or angry), people tend to be pessimistic (optimistic) and risk-averse (risk-tolerant).
    • Social processes aggregate feelings, and self-reinforcing social processes can produce large shifts in market sentiment.
  • Firm management and advisors sometimes exploit irrationality of investors.
  • Social finance (how financial ideas spread/evolve and how social processes affect financial outcomes) promises to enhance insights regarding:
    • Where investment and corporate heuristics come from and how they change.
    • How aggregate sentiment evolves.
    • Causes and consequences of financial bubbles and crises.

In summary, behavioral finance encompasses a broad body of research investigating how investor irrationalities manifest as asset pricing anomalies, thereby creating opportunities for rational investors.

The paper includes many references to research that relates irrationalities to pricing anomalies.

Cautions regarding conclusions include:

  • Testing of many different behavioral hypotheses using the same set of data introduces snooping bias, such that published findings tend to overstate strength of anomalies.
  • The proposition that financial markets are fundamentally different from the environment(s) in which human psychology evolved is central to behavioral finance. However, financial markets are large, complex, adaptive systems that are very difficult to model. Behavioral finance researchers may be overconfident that they can delineate rational and irrational behaviors in such contexts. See “Persistence of Diversity in Investor/Trader Beliefs”.
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