Behavioral finance is a science that analyzes why investors often make misguided choices

Behavioral finance is the study of psychological influences on investors and financial markets.
Behavioral finance biases often lead people to make illogical or detrimental investment decisions.
Understanding financial behavior biases can help people make more rational moves with their money.
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Why do even experienced investors buy too late - and then sell too soon?

Why do companies with stock symbols that come earlier in the alphabet have a small but measurable advantage over those that come later?

Why do people refuse to withdraw money from a savings account, even when they're drowning in debt?

It was an attempt to answer puzzling questions like these that the field of behavioral finance developed in the 1980s and 1990s. A branch of psychology that incorporates finance and economics, behavioral finance tries to explain why people make irrational investment decisions - and how this, in turn, causes the stock market and other financial exchanges to make irregular or volatile moves.

Let's look further into this field of study, what it tells us about human economic behavior and our financial blind spots - and how to get a handle on them.

What is behavioral finance?

Behavioral finance - also known as behavioral economics - uses experiments and research to demonstrate something that most of us would have little problem agreeing with: Humans aren't always rational, and the decisions they make are therefore flawed. But behavioral finance goes even further, examining how difficult it can be to rid yourself of these ideas, even if you understand the issues at stake.

The field developed partly in response to the efficient market hypothesis (EMH), a popular theory that holds that the stock market moves in rational, predictable ways. Stocks typically trade at their fair price, and those prices are a reflection of all available information that's available to all. You can't beat the market, in other words, because anything you know already has or soon will be reflected in market prices.

Starting in the 1980s, its founders - including psychologists Daniel Kahneman and Amos Tversky, and economist Robert J. Shiller - gained attention by conducting a series of artful experiments showing participants making misguided, emotional decisions. They would sometimes keep doing so, even after they were told why their choices weren't the optimal ones.

What the behavioral finance researchers quickly found was that investors frequently failed to act rationally and that the markets were full of inefficiencies due to investors' flawed thinking about prices and risk. As Shiller wrote in an influential paper, "we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information."

The costs of irrational financial behavior

Behavioral finance acknowledges that investors have limits to their self-control and are influenced by their emotions, assumptions, and perceptions. These biased and irrational behaviors have real costs. They help account for the difference between what investors should be earning and what they actually manage to take home. DALBAR, a financial research firm, has conducted many studies comparing investors' rate of return against the performance of the market.

For instance, the average investor in equities earned an average annual return of 4.25% in the 20 years between 2000 and 2019. At the same time, the S&P 500 had gone up 6.06%. Fixed-income investors also left money on the table, earning 0.47% in those 20 years. At the same time that a common index fund of bonds, the Bloomberg Barclays U.S. Aggregate Bond Index, pulled in slightly more than 5% a year.

If investors were rational, it seems as if they should have been able to come much closer to the S&P 500, or even to have exceeded it if they were willing to take on more risk. But they did worse.

Financial behavioral biases

There is a multitude of self-defeating or counterproductive behaviors that bring human beings down. Financial behaviorists call these biases. Here are some of the most common.

Anchoring bias

Anchoring is our tendency to estimate worth or value based on whatever numbers we have access to. For instance, people with a lot of money who mainly associate with other high-net-worth individuals are likely to overestimate the cost of everyday things. Case in point: The famous line by "Arrested Development" character Lucille Bluth: "I mean, it's one banana, Michael. What could it cost, ten dollars?"

Somewhat oddly, anchoring occurs even with numbers that have nothing to do with each other. In one often-duplicated class experiment, a teacher conducts an auction of random household items. Every student is asked to write down their social security number's last two digits and then their maximum bid for each item. Students with the highest social security numbers tend to bid higher than those with lower sequences. Those irrelevant social security numbers helped anchor students' idea of a fair auction price, even though there's obviously no connection between the two.

In investing, anchoring comes into play with the use of irrelevant (or no-longer relevant) information to evaluate an asset or a financial instrument - a psychological benchmark that influences you too much. For instance, suppose a company's stock goes up 25% in the first week of its IPO, its stock market debut. In subsequent months and years, you keep clinging to the idea it will keep rising 25%, even in the face of new information about the company and lower progress in its shares.

The disposition effect

The disposition effect gets its name from a 1985 research paper, "The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence." Its core tenet: "People dislike incurring losses much more than they enjoy making gains," as authors Meir Statman and Hersh Shefrin wrote.

The disposition effect in a nutshell explains why even experienced investors mistime their investment moves. If a stock's going up, we get anxious and tend to lock in the value too quickly by selling. At the same time, we are too slow to cut our losses on dogs, keeping our losers in hopes that they'll turn the corner. But usually, they don't, and we lose even more.

Mental accounting

Money is fungible - that is, interchangeable; all funds are the same, regardless of where they come from or are used for. Yet, in a variety of ways we treat some kinds of money differently - assigning it different values or classifications. This is called mental accounting, a term coined by the behavioral economist Richard H. Thaler. According to Thayer, "Putting labels on money has a long history and serves a purpose . . . it starts with a sensible reason but then people take it to places that don't make any sense."

For example: treating an IRS refund as a windfall. It's not - it's your own money coming back to you. Or refusing to touch a legacy -" it's money my dad left me" - when you're deep in debt. Or maintaining a low-paying savings account "because it's for the kids' college," instead of investing in something still relatively safe, but with a better return.

Herd behavior

You've probably heard of herd mentality - a tendency to follow and copy what others are doing. In the behavioral finance context, it refers to mimicking what other investors or the market overall is doing, without a rhyme or reason of your own. Throughout financial history, herd behavior has been behind many a speculative frenzy in the stock market, like the dotcom bubble of the late 1990s - and the cause of many stock market crashes and panics.

Emotional behavioral finance biases

All biases have a psychological component. But some especially reflect emotions and our feelings. Some of the most common include:

Overconfidence bias: the tendency to think we know more than we do.
Hindsight bias: the tendency to think we knew all along what was going to happen - like if you happened to liquidate a lot of your holdings back in February 2020, a month before the COVID-19-induced market crash. In fact, you were probably making at best an educated guess, like the rest of us, but you might remember it as a brilliant bit of predictive insight.
Confirmation bias: the tendency just to see or seek out information that fits in with existing beliefs, in a self-reinforcing loop. A related syndrome is belief preservation: resisting news that goes against what we believe.

How to deal with behavioral financial biases

How can you avoid or remain unswayed by your financial biases? You can't, at least not entirely. But just knowing that syndromes like these exist will help some. A few other tips:

Before buying a stock or mutual fund, decide just how much it would have to go down or up before you'd sell it. This could help keep you from holding on too long if it falls, or getting too anxious to sell as soon as it rises. Creating a long-term financial plan will also help keep distracting emotions at bay.
Since losses hurt more than gains make us feel good, accentuate the negative when thinking about saving and investing. "I'm saving money to avoid severe budgeting and debts when I'm old" could motivate you more than "I'm saving to create a nest egg for the future."
Keep track of the decisions you made about money, and why you made them. Then revisit them in a year. Seeing how much indecision you had to deal with in the past (as well as seeing what you got wrong) will prevent overconfidence in your future investing decisions.
Try getting out of your bubble: If almost everyone you're exposed to is doing the same thing and pursuing the same investments, they may of course be right. But think of how much more certain you'll be if, instead of just following the crowd, you actively seek out dissenting views and strategies. Don't blindly follow investing trends - buying a stock just because it's hot.
Remember, money is fungible. If you find yourself with funds you didn't expect, take a moment to figure out where they can do the most good, especially if you have bills to pay. By the same token, if you have a great need for something or are being choked by debt, don't hold back on buying it or dealing with it just because you have to get the money from another part of your budget - even an emergency fund.

The financial takeaway

Behavioral finance tries to measure the miscalculations and misguided moves that people make with their money. The idea "is not that people are irrational, but that they are predictably irrational," as Seton Hall finance professor Jennifer Itzkowitz, co-author of the " ABCs of Trading: Behavioral Biases affect Stock Turnover" study, said in a "Seton Hall" magazine article.

Anchoring one group of numbers with irrelevant figures, being excessively loss-averse, and putting money into artificial, mental accounting buckets that don't help us with our goals are all ways our behavioral financial biases can lead us astray.

Many of these financial behavioral biases are baked into the ways we process, think, and feel. Still, investors can try to combat them. Creating a system of accountability for yourself, reframing wins and losses, and trying to stay away from groupthink are all time-tested methods to improve the way to make decisions about your investments and finances.

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Behavioral finance is a science that analyzes why investors often make misguided choices

What is behavioral finance?

The costs of irrational financial behavior