Traditional finance theory assumes that people make rational investment decisions when choosing between different asset classes in light of potential risk/reward tradeoffs, and that they rationally consider their overall risk/reward goals. Even for financial experts, this task can be challenging, so for most people the complexity of asset allocation and security selection decisions according to rational conventional economic theory is problematic.
Advocates of behavioral finance claim that the standard financing model does not explain well how most people make financial decisions. It attempts to explain market anomalies and other market activity that cannot be explained by traditional financing models and offers alternative explanations for the central question of why security prices deviate from their fundamental values.
Some of the key concepts of behavioral finance are listed below.
Heuristics refer to the "rules of thumb," educated guesses, or "gut feelings" that people use to make decisions in complex, uncertain environments.
As an example, we will often look for comparable situations we are currently facing and try to find a pattern or similarity in the circumstances that will help us understand how best to deal with the current situation. Sometimes this is expressed as an appeal to common sense, although the term is not nearly as clear as one would like.
For example, it concludes that:
Use of Information - Individuals may not consider all relevant information; This could explain why investors rely on past performance and do not fully consider risk and expected return.
Investment Inertia – Once people have made decisions, they tend to leave them unchanged. Status quo bias is people's tendency to stick with their previous decisions, especially in situations that are too complex. There is evidence that once people have made asset allocation decisions, they tend to leave them unchanged. The status quo then becomes people's default position.
Representativeness - when decisions must be made under uncertainty and insufficient information, a person will tend to recognize patterns and similarities with previous contexts where none may exist. This is used to explain a behavior known as "herding". Herding occurs when investors tend to follow each other somewhat irrationally and are led into speculative "bubbles" by an exuberant and bullish market.
Overconfidence – Overconfidence causes many investors to overestimate their ability to predict.
Anchoring – People tend to base their decisions on often arbitrarily chosen reference points. People are not only interested in what they have, but how it compares to what they used to have and what they could have had. For example, whether people decide to sell stocks is influenced by what they paid for it.
Gambler Error - This is the belief that there are recognizable sequences or patterns that can be observed in repeated independent attempts at a random process, such as spinning a roulette wheel repeatedly.
Availability – This is the notion that when something comes to mind when it comes to considering a question or making a judgment, what comes to mind must be relevant and important. This means investors are overweighting more memorable facts and evidence.
Based on the above heuristics, prospect theory was developed, which attempts to describe and explain the seemingly paradoxical states of mind that often manifest themselves in decision-making processes of individuals under uncertainty. Kahneman and Tversky's prospect theory argues that the price investors pay for a stock has a crucial impact on its subsequent behavior (the so-called disposition effect). Investors also react more emotionally to losses than to similarly sized gains. Empirical studies suggest that the pain of a $1 loss equals the exhilaration of a $2-$2.5 gain. As a result, investors often sell their winners quickly to lock in profits, limiting the ability of stock prices to quickly adjust to positive news. The reverse is true for bad news, as investors are reluctant to crystallize losses. This means that intrinsic value is not reached as quickly, creating a momentum effect. Some of the key concepts addressed by perspective theory are:
Loss Aversion – Research in behavioral finance has found that investors have conflicting attitudes to risk. Individuals play it safe in protecting profits but are reluctant to take losses.
Regret Aversion – This arises from a desire to avoid the pain of regret from a bad investment decision. Aversion to regret can encourage investors to hold poorly performing stocks because avoiding selling them also avoids the fact that a bad investment decision was made. The desire to avoid regret can also influence new investment decisions, as people are often reluctant to invest new amounts in assets or markets that have performed poorly in the recent past.
Mental Accounting – Behavioral Finance has challenged the standard economic assumption that individuals treat income and wealth types equally. It could mean, for example, that individuals want to invest their own pension contribution as safely as possible, while the desire for higher returns with the employer's contribution or state tax is higher.
Information and noise trader – The right way to be a successful investor, according to portfolio theory, is to become an “information trader” because having quality information is key to a profitable investment strategy. Since "noise" is the opposite of information, people who trade noise make trading decisions without the use of fundamentals, relying instead on trends, sentiment, anomalies and momentum. Because noise traders, by definition, do not trade on fundamentals, they are said to be more likely to buy high and sell low.
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