I think one of the major results of the psychology of decision making is that people’s attitudes and feelings about losses and gains are really not symmetric. So we really feel more pain when we lose $10,000 than we feel pleasure when we get $10,000. ~Daniel Kahneman
According to Traditional Finance, investors are, for the most part, rational “wealth maximizers.” This theory says man acts only in a way that maximizes his returns and minimizes his risks. In contrast, Behavioral Finance attempts to understand and explain actual investor behavior versus theories of investor behavior.
Emotion and deeply ingrained biases influence our decisions, causing us to behave in unpredictable or irrational ways. In fact, some may consider it to be predictably irrational. Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
Daniel Kahneman and Amos Tversky
Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the fathers of behavioral economics/finance. Since their initial collaborations in the late 1960s, this duo has published about 200 works, most of which relate to psychological concepts with implications for behavioral finance. In 2002, Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics.
It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what is going on. ~Amos Tversky
Investors are influenced by two primary behavioral biases: Cognitive Errors and Emotional Biases
Cognitive Errors deal with how people think and result from memory and information-processing errors and are, therefore, the result of faulty reasoning.
There are two sets of cognitive errors: belief perseverance biases and information-processing biases.
Belief perseverance biases are those in which people have a hard time modifying their beliefs, even when faced with information to the contrary. Belief perseverance biases include cognitive dissonance, conservatism, confirmation, representativeness, illusion of control, and hindsight.
Information-processing biases are those in which people make errors in their thinking when processing information related to a financial decision. The information-processing biases include anchoring and adjustment, mental accounting, framing, availability, self-attribution, outcome, and recency.
Emotional biases are the result of reasoning influenced by feelings.
It is a very human reaction to feel mentally uncomfortable when new information contradicts information you previously held to be true–a psychological phenomenon known as cognitive dissonance. For example, two thousand years after the Greek philosopher Pythagoras proposed the world is round, Columbus was still trying to refute the common belief that it was flat by attempting to circumnavigate the globe.
Emotional biases are based on feelings rather than facts. Emotions often overpower our thinking during times of stress. All of us have likely made irrational decisions at some time in our lives. Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, regret aversion, and affinity.
Behavioral Finance in Practice
Many wealth management practitioners note that clients often go to great lengths to rationalize decisions on prior investments, especially failed investments. Moreover, people displaying this tendency might also irrationally delay unloading assets that are not generating adequate returns.
In both cases, the effects of cognitive dissonance are preventing investors from acting rationally and, in certain cases, preventing them from realizing losses for tax purposes and reallocating at the earliest opportunity. Furthermore, and perhaps even more important, the need to maintain self-esteem may prevent investors from learning from their mistakes. To ameliorate dissonance arising from the pursuit of what they perceive to be two incompatible goals— self-validation and acknowledgment of past mistakes—investors will often attribute their failures to chance rather than to poor decision making.
People who miss opportunities to learn from past miscalculations are likely to miscalculate again—renewing a cycle of anxiety, discomfort, dissonance, and denial.
Intelligent Investing wants to break this cycle, and by understanding behavioral finance, we can.
Watch more behavioral finance videos here.