June 26, 2015    7 minute read

Behavioural Finance – Theory And Practice

   June 26, 2015    7 minute read

Behavioural Finance – Theory And Practice

Emotions and irrational thinking often influence (economic) decisions. For example, someone might invest in Apple just because he likes Apple products but without any fundamental analysis behind the investment decision. One might argue now that this can only happen to inexperienced, unprofessional investors who should leave the management of their money to the professionals. However, even professionals struggle with irrational influences on their decisions everyday as will be discussed later in this article. The field of behavioural economics and particularly its sub-discipline behavioural finance has attracted more attention of late, primarily due to discrepancies between neoclassical economics and real world phenomena become evident. What behavioural finance is, what its differences to conventional economics are and how it is applicable in practice is discussed in the following.

Behavioural Economics vs. Neo-Classical Economics

Behavioural finance, a branch of behavioural economics, deals with the effect psychological and emotional factors have on human economic decisions. Taken further it also examines the effects of these factors on asset prices. However, psychological influences are not a completely new area in economics. There was a time where microeconomics already contained parts of psychological considerations. Take, for instance, Adam Smith’s work The Theory of Moral Sentiment, which dealt with psychological explanations of individual behaviour long before the term of behavioural finance was even invented.

During the reshaping of economics to our modern neoclassical economics, however, economists wanted to change the subject to make it more similar to the established natural sciences. They did so by introducing mathematical models and developing the concept of the homo economicus whose decision-making was based entirely on rationality, which from today’s view, seems somewhat unrealistic. Taking a look at the assumptions made by behavioural economists reveals the differences to neoclassical economics assumptions:

In contrast to conventional economics, behavioural economics examines economic analyses based on more realistic assumptions about how individuals behave in the real world. To give a taste of what is meant by that, below are a few of examples of how assumptions differ in both disciplines:

  • While conventional economics assumes that people are endowed with the ability to efficiently obtain and process all relevant information, behavioural economics only assumes that people are “boundedly” rational, meaning they do the best they can to act rational given the natural constraints they face.
  • Conventional economics also assumes that people always make decisions under perfect decision-making conditions, in which they have all the information they need to make the best possible decision. Behavioural economics does assume that people often face decision-making environments, which are far from the described conditions.
  • Another divergence lies in the question of whether or not relative income is of importance for people. While conventional economics concludes that people’s happiness only depends on their own income, independently on how much your neighbours or friends earn, behavioural economics says that relative income does matter and people derive happiness from earning more than other people.
  • Additionally, an assumption of conventional economics regarding decision-making stipulates that people aren’t influenced by anyone or anything in their decision-making process. In contrast to this, behavioural economics suggests that people are influenced by their peers, by their past, and by the general decision circumstances.
  • Looking at the upcoming importance of sustainability of investments, another assumption of conventional economics seems questionable. Namely, it was always assumed that people are narrowly self-interested and do not consider anyone else’s benefit in consequence of their decisions. Behavioural economists support the view that many people act out of self-interest, however they see behaviour also influenced by altruism and ethics.
  • Moreover, behavioural economists doubt that markets are efficient. This is one of the most important assumptions of behavioural economics as it calls into question one of the underlying fundamentals of modern economics theory, namely the efficient market hypothesis.

Application of Behavioural Finance in Practice

As one can observe from the differences between conventional and behavioural economics, their impacts reach onto diverse fields. While some aspects address the area of economic decision-making or market efficiency, others are connected to such exotic field like human happiness. Extending this realisation, it is interesting to see how the assumptions made by behavioural economists are applied in practice. Findings from behavioural finance are used in relation to retirement savings schemes within firms. For example, data suggests that company retirement schemes where participants are automatically enrolled with the option to leave the programme have a much higher participation rate (98%) than those schemes that participants need to actively sign up for themselves. This is mainly due to the phenomenon that people tend to be “lazy” when dealing with some parts of their personal finances, even though it would be to their advantage to be more proactive.

Whilst many universities are still laggards with regards to behavioural economics as part of their curriculums, the finance industry has been using insights from behavioural finance for several years. This use is justified for the finance industry in particular as investing always involves uncertainty and behavioural finance is essentially the science of how people make economic decisions under uncertainty. This makes behavioural finance an inevitable part of the finance industry, which is especially true for traders, as I will show with some examples.

One of the theories used is prospect theory. Developed by Kahneman and Tversky, both Nobel Prize winners, prospect theory models decision-making under uncertainty on the outcomes.

The first important conclusion from prospect theory is that the same amount of losses is perceived stronger and with more negative emotions than the same amount of gains is felt positively. In other words:

If someone loses $100, it will have a stronger negative impact on their mental state than a $100 gain would have on positive feelings.

Additionally, prospect theory suggests that once someone has won (earned) a lot of money, the incremental satisfaction of winning (earning) decreases. So, the more someone earns, the less satisfaction they can get from any additional money earned. This also holds for the opposite, i.e. if a trader has already taken a big loss, additional losses are perceived as less influential on the trader’s mental state. Being aware of this can prevent traders from making wrong decisions that are based on previously experienced gains or losses instead of solely concentrating on rational factors to come to a trading decision.

Another important concept in trading is that of herd behaviour. It describes the tendency for individuals to follow the majority, regardless of whether or not there is a rational reason for the majority’s behaviour. The interesting point here is that, if these individuals were on their own, they would most likely act differently from the manner by which they behave in the herd. The reasons for this irrational herd behaviour lies in the human nature, as most people are very sociable and have a desire to be accepted by a group. This social pressure triggers the irrational behaviour described above. A second factor is the (irrational) assumption that such a big large group of people is unlikely to be wrong.

A third aspect traders pay attention to is called confirmation bias. This psychological phenomenon suggests that investors will pay more attention to information that supports their already existing view on an investing decision while neglecting information that would contradict their opinion.

Summing up, it is fair to say that behavioural economics with its sub-discipline of behavioural finance is on a good way of becoming a fix part of modern economics as more and more people feel that under its current assumptions, which are often considered as unrealistic, neoclassical economics might need an additional component. And for this to be achieved, the real-life applications of behavioural finance can only be an advantage for the discipline.

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