Behavioral finance is the study of investors’ behavior in making investment decisions on an individual or collective level. While markets generally tend to be overall efficient, the same may not be true for its constituents i.e. the investors. If one group of investors behaves irrationally, the remaining will notice it and respond appropriately, bringing the overall market closer to efficiency. Following human biases/tendencies can lead to market anomalies:
- Loss aversion is the tendency of human beings to dislike loss more than the same amount of gain. This bias runs counter to the risk-aversion assumption that most financial models factor in. Risk aversion is the tendency of investors to avoid risk and to demand an extra return for additional risk exposure. A loss-averse investor will, however, become over protective to limit her losses and such tendency may lead to over-reaction in the markets.
- Herding refers to the tendency of investors to get on the same side of the trade leading to either over-or-under-reaction. Herding may or may not be based on the information.
- Information cascade refers to the phenomenon when some investors take on a certain trade based on their understanding and their decision influences the decision of a large number of other investors. The followers in these cases often forego their own investing preferences. Such correlation in stock prices can lead to overreaction The positive side of these cascades is that it improves the information available to the investors.
- Overconfidence bias comes in when investors overestimate their ability to interpret information and forecast a security’s price. This bias can lead to mispricing only if there is a sufficiently large number of overconfident investors.
- Other biases
- Representativeness: when investors use familiar concepts to assess new information and probability of outcomes.
- Mental accounting: when investors keep mental accounts of different investments and treat them differently.
- Conservatism: when investors resist action on new information and try to stick to their previous views
- Narrow framing: when investors focus on issues in isolation respond on the basis of how the issues were posed
While behavioral finance may not explain all the market anomalies, it is an important tool that most seasoned investors employ while making investment decisions. It also offers insights into market functioning. If market efficiency requires rational decisions on part of investors, human psychology suggests they can't behave rationally all the time. However, if market efficiency suggests that investors can’t beat the market consistently on a risk-adjusted basis, then there is ample evidence in favor of market efficiency.
Check your concepts:
(47.11) An investor showing the tendency of loss aversion is more likely to be showing:
(a) Risk-averse behavior
(b) Risk neutral behavior
(c) Risk-seeking behavior
(47.12) John has invested in a biotechnology company. The company was researching a drug that had the potential to change the market. But after working on the drug for a couple of years, the company couldn't show any significant progress and finally dropped the idea and started working on already available on generic drugs only. After getting this information, John did not immediately sell the shares and waited for a couple of months and by that time the stock had decreased by 80 percent in its value. Which of the following behavioral bias is most likely to be shown by John?
(a) Overconfidence bias
(b) Conservatism bias
(c) Representativeness bias
Solutions:
(47.11) Correct Answer is A: A loss averse investor do not want to book losses and in doing so, he takes more and more risk and thus show risk seeking behavior.
(47.12) Correct Answer is B: John is showing the signs of conservatism bias. The investors showing conservatism bias resist action on new information and try to stick to their previous views.
