Behavioral Finance

Behavioral finance is defined as the study of the influence of

psychology on the behavior of financial practitioners and its subsequent
effect on markets. Behavioral finance is based on the notion that a
significant number of investors make financial decisions that are subject to
irrational behavioral biases. An individuals behavioral biases can lead to a
significant loss of wealth for the individual. Behavioral biases made by
investors affect the market as well by causing inefficient allocation of capital
and diminishing the value of the entire market. This paper aims to describe
various irrational investment behaviors and propose methods that decrease
the rate of irrational investments by encouraging people to allocate more
money into less risky assets. In order to reduce the frequency of irrational
investments decisions, financial institutions and governments should work
together to investigate and prevent irrational investments. Ultimately, the
government should regulate investors, but current investment product
capabilities are limited and underutilized.
Behavioral finance
Behavioral finance studies the effect of human behavior on stock
market abnormalities. People cannot always be trusted to make rational
decisions, especially when their own money is involved. Those with previous
investing experience tend to make more logical decisions with their money
when investing, while the average person may be tempted to make a fatal,
spur of the moment decision with their money.
In the late nineteenth century, scholars were intrigued to explore the
connection between psychology and the movement of the stock market,

which lead to experiments on human behavior. In 1912, Selden wrote the

Psychology of the Stock Market, which first indicated that the movement of
prices on the exchange are, to a large degree, dependent on the mental
attitude of investors. Following in Seldens footsteps were numbers of
scholars who conducted research on how peoples cognition affects their
investing. In 1964, Pratt combined the utility functions with investors risk
preference, creating new methods to evaluate investment portfolios. Over the
years, researchers developed technical analysis to predict the return on the
stock market and found the amount of abnormal return was not addressed
by elements used for prediction. In 1985, Werner F. M. De Bondt and Richard
Thaler published Does the Stock Market Overreact?, in which the concept of
behavioral finance was used to explain how investors reactions to
unexpected news influences the stock market.
Humans irrational behavior was studied by psychologists Daniel
Kahneman and Amos Tversky in a simple coin toss experiment. In considering
tosses of a coin for heads or tails, people picked the sequence of H-H-T-H-T-TH as more likely to appear than H-H-H-T-T-T, which appears less random.
People expect that an example that looks more randomized is more likely,
even though the examples proposed are equally as likely to occur statistically.

Over the years, psychologists and financial experts have discovered

behavioral biases that affect peoples investment choices and tend to lead to
poor investment decisions. When investors only pay attention to selective
information that supports their investment strategies, now coined
confirmation bias, they avoid critical reports that provide contradictory

evidence and make investment choices based off of their biased view of the
market. The long-short bias refers to investors who always bet on the long
shot stock because it promises a very high return. Since these stocks tend to
fail more often than not, investors lose their money when betting on these
long shot stocks. Investors do not rely on rational facts, but tend to base their
decisions on the price at which the stock was purchased, called anchoring
bias. Investors lose their money and then proceed to take greater risks to
make up for it. One of the most extreme examples is former derivatives
broker, Nicholas Leeson. Leeson spent years making fraudulent investments
to make up for a former loss, which eventually led to the collapse of Britains
oldest merchant bank and his subsequent imprisonment. Many investors also
sell their stock too quickly when the prices starts to increase and act
surprised when they sustain a loss.
Loss aversion refers to a persons preference to avoid loss more than
enjoying the pleasure of winning. A perfect example is when the lottery
jackpot gets so large, it starts making headlines. The odds of a person
winning do not increase with the size of the jackpot and the risk of losing
money is extremely high, but more people start buying lottery tickets
because they feel that they are missing out on a chance to win big. Even
though the odds are extremely low, they are still above zero, and peoples
brains want to avoid any type of loss.
Investors mistakenly believe that their knowledge of the stock market
and their previous experience in finance gives them an advantage over
others when investing. Although investors do have an advantage over the
average person dabbling in stocks, they still are just as likely to make the

same mistakes as an average person due to proven psychological

phenomenon. An investor's belief that they know better than anyone else is
called overconfidence, and can lead to faulty investment choices.
A persons culture affects how they invest. In the US, investors are
more likely to take risks and bet on extremely unlikely events believing it will
lead to a positive outcome. In 2014, when the Ebola epidemic was
threatening to spread to the US, pharmaceutical companies raced to develop
vaccines to prevent the further spreading of the disease. The stock prices of
those companies surged incredibly as investors bet on the success of those
medicines. One company called Lakeland Industries had its stock price rise
from $7 to $27 within two weeks, and dropped back down to $10 within a
month. Investors tend to lose money when chasing after riskier assets, as
shown in abnormal situations like the Ebola epidemic. According to the study
of Professor Thorsten Hens of the Swiss Finance Institute, European investors
are more patient and have a tendency towards lower risk assets. European
investors do not bet on extreme events in order to gain huge returns, but put
their their money into wealth management companies or invest in stable
stocks.
The aggregate effects of irrational investment can boost or undermine
the financial market, causing positive or negative bubbles. In the world of
finance and economics, the price of stocks or goods should be equal to their
intrinsic value. If investors purchase the shares whose price is already in
excess of its intrinsic value, the market moves towards a positive bubble, and
vice versa. Both actions cause inefficient allocation of capital. Since the entire
market operates based on a smooth flow of capital, misallocation will

ultimately lead a small number of companies controlling an excessive amount

of money, while the remainder of companies lack the capital to grow their
business. In order to prevent this bubble effect, investors must be
encouraged to make rational investment decisions, which will lead to an
increase in the efficiency of the market.
Solution
Before irrational investment choices can be eradicated, the belief that
less risky assets deliver less return must be eliminated. The government
should encourage people to invest rationally. Even though the government
cannot conduct regulations to control peoples investing strategies, they
should take the majority of the responsibility in guiding investors and
financial institutions towards a more efficient market. The government should
inspire people to put an increasing amount of money in their retirement
account. This could be made possible by initiating a program that requires
employers to contribute to employees retirement savings. To ensure that
people do not dip into these savings until retirement, regulations should be
put in place that do not let the individual access the money until their
retirement.
People cannot be taught to stop being irrational, but the government
can cooperate with financial institutions and develop money management
programs to educate and provide professional advice to investors. Financial
institutions including banks, mutual funds and asset management companies
should use their professional knowledge to convince individual investors to
put a larger amount of money in their companies in order to avoid individual
exposure. Investment education should be given a higher priority in schools.

Public schools could start offering classes on investing and money

management that could prepare students for future endeavors. A generation
that is well educated on investing techniques and strategies could create a
healthier future economy.
Information is critical to making investment decisions, but
overwhelming amounts of information cannot be processed, which leads to
poor investment choices. The best way to release relevant and important
information to each individual is through media companies such as
Bloomberg, Yahoo Finance and Money Start. These media outlets can push
news or earning reports to investors in a timely manner and according to
each investors portfolio, so each individual could focus more on the
information that really affects their investing portfolio. These companies can
also develop mobile applications that could allow investors to access
information and their portfolio at any time and place. That way, investors do
not have to wait until the market has already moved forward.
There is no definitive way to eliminate irrational behavior since all
humans are irrational and will, from time to time, make emotionally driven
decisions. Fortunately, all people behave irrationally in a similar way, and
scientists have been able to distinguish a behavioral pattern. Firstly, there is
a pattern to the amount of overconfidence an individual feels that varies by
gender and marital status. Single men have the highest levels of
overconfidence, followed by married men, married women and lastly single
women. Studies have shown that single women tend to avoid changing their
investment choices the most and consequently experience the highest
returns and lowest losses. Knowing this can help financial professionals to

advise their clients and encourage individuals to adhere to their original

investment options.
People tend to invest in stocks that are familiar to them. This is best
exemplified by people overinvesting in their employers stocks, which can lead
to dire consequences, as exemplified Enron. When Enron went bankrupt, not
only did people lose their jobs, but a large share of their 401Ks as well. The
collapse of such a large corporation affects the stock market, and
preventative measures should be taken to avoid this from occurring in the
future. This financial disaster could have been avoided had these employees
been encouraged to diversify their portfolio and investigate some new stock
options. In an ideal world, regulations would be put in place by the
government to limit the amount an individual could invest in one company.
Such regulations would also mean the end of a free market, so instead, it is
the responsibility of investment advisors to aid their clients in making smart
decisions with their money. Investors must be careful not to take this to
extreme measures, because naive diversification could have just as dire
consequences.
Behavioral finance came about as a result of psychologists and
economists alike growing interested in the irrational behaviors of investors
and humans in general. Even the most experienced investors make fatal
mistakes that lead to countless dollars lost due to simple irrational behavioral
patterns that have been uncovered by psychologists. Educating the public
about these irrational behaviors through government programs, classes in
schools and news channels can help investors of the present day and future
alike avoid these mistakes and keep the market healthy. Additionally, the

media can help individuals understand the market by disclosing valid

information. Financial institutions should encourage investors to seek
professional advice regularly.

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