Understanding Behavioral Finance

Behavioral Finance

Investment Optimisation

Behavioral Finance

Behavioral finance is the study of financial markets and their psychological influence on investors. At its core, behavioral finance identifies that a rational thought and decision-making process is often flawed with respect to financial markets, and often leads to inefficiencies and mispricing in investments.

Having a working knowledge of behavioral finance can be beneficial to any would-be investor, through knowledge, you can start to identify your own persistent and subconscious biases that influence the way that you make financial decisions. 

Effective Markets

In the 1980’s finance researchers proposed the efficient market hypothesis (EMH) that is a popular theory that the stock market moves in rational, and predictable ways. In reality, investment markets are full of inefficiencies due to investors’ flawed thinking about prices and risk, resulting in the Efficient Market Hypothesis not always holding up under scrutiny.

Supporters of EMH often prefer index funds or certain exchange traded funds (ETFs) because those funds are passively managed and simply attempt to match, not outperform the overall market. Investors who prefer passive investment often refer to a saying: “If you can’t beat ’em, join ’em”. Holding true to this saying, these investors typically buy an index fund that invests in the same securities as the benchmark index i.e the ASX 200 or S&P 500.

Investors who don’t necessarily agree with EMH, and who believe different forms of analysis and a working knowledge of an asset class can help an investor beat the overall market return, typically prefer active management or professionally tailored portfolios. Many Australians liken the skills in the property market and often state “I bought at a great price”.

The bottom line is that whatever your preference, passive, active or a combination, a long-term buy and hold strategy is useful as capital markets are mostly unpredictable with random up and down movements in price that spark a huge range of emotions and behaviors.

For more information on EMH, refer to a white paper written by Burton G Malkiel:


Why Learn About Behavioral Finance?

By understanding how, when, and why your behavior may deviate from your own rational expectations, behavioral finance provides a blueprint to help everyone make better, more rational decisions when it comes to their finances.

Understanding Economic and Financial Heuristics

Heuristics are mental shortcuts that allow people to solve problems and make judgments quickly and efficiently. These rule-of-thumb strategies shorten decision-making time and allow people to function without constantly stopping to think about their next course of action.

Herbert Simon, a behavioral economist, surmised that most people use heuristics when confronted with a complex decision, such as a decision to buy or sell an asset with unknown consequences. An example of a common heuristic is to assume that past investment performance indicates future returns.

Although that seems to make sense on the surface, it doesn’t take into account changes in the economy, or how fully valued an investment has become. Another example is seeing a “sale price” and assuming that it’s a good deal because it’s below the normal price. Sometimes it is a good deal, but other times it isn’t (Boxing Day sales). This heuristic is based on the tendency to believe a reference point is real because of how it is reported. In this case, it’s the price a tag says is the normal price. Making a purchase decision based on an inaccurate reference number can result in negative financial consequences. 

Fortunately, by creating an awareness of errors caused by heuristics, you can start to adjust your decision-making process and this is where a financial adviser can be of real value when acting as a sounding board. In addition, you can start to develop an understanding of which heuristics are reliable and which you can act upon.

Understanding Behavioral Finance Biases

Heuristics involving economic and financial matters often lead to inaccurate judgments and beliefs, resulting is cognitive biases. Each bias mentioned below can adversely affect your behavior as an investor when making sound and rational decisions. The most common cognitive biases attributed to financial decision making include:

  • Loss aversion: Trying to avoid a loss more so than on recognizing the potential to create investment gains, leading to desirable investment or finance opportunities being missed.
  • Confirmation bias: Paying close attention to information that confirms a finance or investment belief and ignoring any information that contradicts it.
  • Familiarity bias: Paying close attention and only considering those investments which you are aware of and understand.
  • Self-attribution bias: Believing that good investment outcomes are the result of skill, and undesirable results are caused by bad luck.
  • Framing bias: Reacting to a particular finance opportunity based on how it is presented.
  • Representative bias: Believing that two things or events are more closely correlated than they really are.