UNDERSTANDING
BEHAVIORAL FINANCE

Learning about the concept of behavioral finance can help you to understand how psychology and investing intersect and presents insights into investor behavior and market dynamics.

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On a micro level, behavioral finance can be used to understand why investors make the decisions they do. On a macro level, concepts of behavioral finance can offer insights into market anomalies. 

Looking past what is happening and focusing instead on why it is happening will deepen an investor’s understanding of the circumstances in which individuals and markets can behave irrationally. These insights are important as when understood, they can help investors to understand how cognitive biases and emotional responses shape investment decisions and influence market trends.

The foundations of behavioral finance

The foundations of behavioral finance can be traced back to 1912, when George C. Selden’s book, Psychology of the Stock Market, catalyzed decades of research into the concept. A school of thought soon developed to explore the reasons why individuals and groups sometimes make the wrong investment decisions.

Key concepts and their implications

Behavioral finance is based on psychological research. While the focus of the study is irrational behavior, there are some predictable patterns that appear. These key concepts break down these patterns, and can help to explain why investors make the decisions they do:

Concept	Impact
Overconfidence	This happens when individuals believe that they have a better understanding of a situation or their own abilities than they really do.
Emotional gap	This term explains how emotions, specifically fear and greed, can cloud judgment. They are particularly challenging to investors trading in fast-moving markets.
Prospect theory	Prospect theory assumes that individuals value gains and losses differently, and decisions are made based on perceived gains rather than perceived losses.  Also referred to as “loss-aversion,” the underlying concept assumes that if two equal options are presented to an individual, with one presented in terms of potential gains and the other in terms of potential losses, they will choose the former.
Mental accounting	Decisions on how you manage money can be influenced by how you gained that money. It is likely that you will be less inclined to invest money in speculative investments if you earned it through hard work than if you won it in a lottery.
Anchoring	Deep-rooted habits can be hard to break, even if doing so would be beneficial. For instance, if you have invested in stocks on a monthly basis for many years, you may be reluctant to adjust your approach, even if an attractive, alternative opportunity presents itself.
Herd behavior	All asset prices are determined by supply and demand, but sometimes price moves can loop back and influence those two factors. When this occurs, it can trigger “irrational” asset bubbles and stock market crashes.
Behavioral biases	There are other thought processes to consider, particularly biases. These sub-conscious traits are part of fundamental human characteristics and can sway your investment decision-making. Some biases are more prevalent at the planning stage of an investment strategy, while others become more apparent during the purchase and holding stage of an investment.

Behavioral finance in market analysis

Behavioral biases and emotion-driven decision-making not only impact an individual investor’s decision-making. If enough investors show behavioral biases and emotion-led behavior at the same time, the effects of those actions have the potential to extend to, and impact, the wider market. 

Market anomalies explained

Classical economic theory assumes that markets operate efficiently (known as “the efficient market hypothesis”). This hypothesis is based on the assumption that all market participants have perfect knowledge of the factors that influence price. 

In reality, this is not the case. A quick scan of historical market trends highlights how asset prices can often be out of sync with standard valuation metrics. These moments are known as market anomalies. 

Information gaps are among the most common reasons that market anomalies occur. Price anomalies often lead to market volatility, which might result in significantly over or underpriced stocks, and can create cycles of panic-led behavior. This might include buying at a high price due to the fear of missing out (“FOMO investing”), or reactive and herd behavior that can result in panic sell-offs at suboptimal price points.

Psychological triggers in investment choices

Some market anomalies are relatively easy to anticipate, while others are more left field. For instance, it’s logical that an upcoming earnings announcement will either please or disappoint investors, and so, the market typically readies itself for potential price movements. Earnings reports can be tracked through an Economic Calendar, and the details of the reports are publicly released. This suggests that earnings serve as a psychological trigger for which investors can prepare.

On the other hand, seasonality and unpredictable shifts in investor sentiment might also trigger emotion-driven behavior. For example, studies show that major indices such as the S&P 500 often decline on the Monday following the spring daylight savings time shift, likely due to traders’ moods being negatively affected by losing an hour of sleep. While this date can be marked in an investor’s calendar and planned for, reacting to negative sentiments stemming from an unexpected global event or news story is more difficult to prepare for. 

For investors, understanding the nature of events and their timing as psychological triggers can help to prepare for market anomalies.

Applying behavioral finance in investment strategies 

Behavioral finance has various effects on the market and as such, can impact investment strategies in various ways. 

By devoting time to developing a better understanding of the personal biases that influence your investment decisions and the psychological triggers that can create market anomalies, you can apply behavioral finance concepts to better understand market dynamics and to better inform your overall investment strategy. 

Identifying and overcoming biases

To apply behavioral finance concepts to your investment strategy, the first step involves acknowledging and addressing biases that may affect your decisions (whether consciously or subconsciously). 

The next step involves analyzing your own trading activities to pinpoint which biases could be influencing your decision-making process, and to what degree. Keeping a detailed log of your trading activity, along with notes on your decision-making and rationale, is crucial for this reflection process and will help you to become a better investor. You might discover patterns such as higher win-loss ratios at specific times of the day, or during market openings or closings. 

Also, consider how you react to news events, how your risk appetite fluctuates during the life of a trade, and what alternative opportunities you might have overlooked due to ingrained habits.

Adopting a well-thought-out strategy is fundamental to successful investing, and incorporating bias analysis into your trade expectations and investment strategies over time allows you to manage your biases in advance.  

Enhancing decision-making with behavioral insights  

Understanding your personal biases can increase your confidence when trading or investing. However, even with a thorough grasp of how your traits might affect your decision-making, external behavioral factors relating to the wider market will still impact and influence your decisions. 

Runaway bull markets, price bubbles and stock market crashes are an inevitable part of investing. Using tried-and-tested valuation techniques can help to identify times when sentiment, rather than fundamentals, is driving price movement.

One effective decision you can make is to keep a percentage of your available capital allocated as cash. This allows for investment when bearish sentiment causes prices to drop suddenly or excessively.

Risk management is also crucial. Scaling back on position size during a bear market may crystallize losses, but avoiding larger losses will reduce the extent to which emotions influence your decision-making. This approach preserves capital for potential reinvestment at lower prices, preventing critical damage to your portfolio.

The markets can remain irrational longer than you can remain solvent.

John Maynard Keynes

Final thoughts

Classical theoretical analysis works on the basis that you will always make successful investment decisions — an assumption that can be incorrect. Behavioral finance helps you to develop a better understanding of how your emotions and habits might impact your investment strategy, and how market sentiment can be illogical. 

Fundamentally, the key to successful investing is having a detailed plan and process that guide every investment decision you make. Such a plan can help you to mitigate the potential negative impacts of behavioral finance. By leveraging insights from behavioral finance concepts, you can better avoid emotion-driven decision-making to stay on track with your overall strategy.

Visit the eToro Academy to learn more about behavioral finance.

Quiz

FAQs

How does behavioral finance differ from traditional financial theories?

Traditional financial theories assume that investors make rational decisions based on having all of the possible information at hand. Behavioral finance aims to explain why that isn’t always the case and offers insights into how understanding behavioral anomalies can help investors improve their decision-making. 

What are some common behavioral biases that investors face?

Numerous biases might influence your decision-making. These include confirmation bias, familiarity bias, experiential bias, heuristic bias, and loss aversion bias. Different investors will be impacted by these biases to different extents.

How can investors use behavioral finance to improve their investment decisions?

Developing a better understanding of behavioral finance involves a degree of self-analysis. It can highlight how bad habits have resulted in investors deviating from the golden rules of investing, and understanding the cause of a problem is the first step towards remedying it.