Behavioral Finance and Investor Psychology: Understanding the Mindset Behind Investments

Behavioral finance is the study of how emotions, biases and heuristics affect investors’ decisions. It uses experiments and research to identify inefficiencies and mispricing in financial markets.

Behavioral finance emerged as a response to the failure of conventional economic theories to explain certain anomalies in market behavior. These were attributed to behavioral errors and cognitive biases.

Emotions

Even the most savvy investors can fall prey to biases and emotions that affect their trading. Especially during times of uncertainty such as geopolitical events, elections and fears of a recession.

Behavioral finance and investor psychology aim to help investors understand and avoid biases and emotional behaviors that can lead to unwise decisions. By identifying these biases and learning how to avoid them, investors can make better financial decisions that will ultimately lead to more positive results.

Emotions get a bad rap when it comes to investing, but that doesn’t mean they aren’t important! Studies in behavioral finance and investor psychology have found that emotions do indeed play a role in investment decision-making.

This study used neuroeconomic techniques to measure anticipatory emotion via skin conductance response (SCR) recordings in four trading games with different share patterns. The study found that gains within an n-shaped share trend were associated with higher levels of anticipatory emotion while losses in a u-shaped share trend were associated with lower levels of anticipatory emotion.

Time preference

Time preference is the tendency for people to discount cash flows in the future more than those that are happening sooner. For example, if you are offered a choice of $100 today or $1,000 in one month, individuals are more likely to choose the latter.

In behavioral finance and investor psychology, time preference plays a role in anchoring and confirmation bias. Anchoring is when investors are slow to react to economic, corporate or market developments because of an irrational attachment to a perceived value.

Similarly, confirmation bias is when investors accept information that confirms their previously held belief in an investment. Confirmation bias can be a major obstacle in making informed financial decisions.

Loss aversion

Loss aversion is a psychological bias that causes people to weigh losses more heavily than gains. In their seminal study, behavioral finance pioneers Kahneman and Tversky found that loss aversion influences investor behavior and financial decision-making.

Essentially, loss aversion explains why people would rather agree to a smaller, sure loss than a larger, less certain gain. Moreover, it is believed that losses are weighed more than twice as intensively as gains when making investment decisions.

Moreover, this bias may be linked to mental illness. In some cases, schizophrenia patients have been reported to be more prone to loss aversion than healthy participants.

Self-serving bias

Self-serving bias is the tendency to attribute positive outcomes or results to one’s own characteristics or abilities. It is an innate heuristic (mental shortcut) that can be difficult to spot in real-life situations.

Self-serving bias can be influenced by age, culture, mental health issues, and other factors. It tends to occur more often in young people than older adults.

However, there is a difference between this type of bias and loss aversion. Loss aversion occurs when investors place a higher priority on avoiding losses than making investment gains.

This bias can make it more difficult for individuals to learn from their mistakes and seek out self-improvement opportunities. Instead, they may avoid risky or impulsive behaviors to try to maintain their perceived image or protect their ego.

This study found that the self-serving bias is exacerbated in public settings when there’s open comparison to others. It also found that it was moderated by result publicity. These findings can help people to recognize their own biases and take action to change them.