Investing is an unpredictable occupation. Various models, tools and agencies will try to convince you otherwise, but while everyone’s looking for an edge, there is always an element of risk. Behavioral finance seeks to explain some of that unpredictability.
Traditional financial theory relies on an idea that would seem to be common sense: people will use all available information to make decisions in the most reasonable manner to increase their own wealth. Behavioral finance deconstructs the idea that people are essentially rational and always work in their own interest. You can think of it as the “human factor” in investing.
The essential idea is that people are influenced by many different things, from the distractions of their daily life, to their personal background. Their decisions, including financial investments, are therefore colored by all these influences. Instead of the most rational decision from a scientific and mathematical standpoint, they make decisions based on personal beliefs, how much sleep they got, preferences, personality, and all manner of other influences.
How can behavioral finance benefit you? You can accept that scientific and mathematical models of finance and investment are useful, but in a limited capacity. You can try to identify and predict some of the irrational ways that investors may act and adjust your own decisions accordingly. This requires greater understanding of human nature, politics, sociology and demographic trends.
It’s important to realize that a greater understanding of behavioral finance should not only be applied to other investors and their influence on the market, but also on your own decision-making. You can interrogate your own beliefs, biases and defaults, and once you understand them, you can proactively look out for them and counteract their effects in your own investing.
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There are a number of models of behavioral finance that can help guide you in what to look out for or factor into your investing. Psychology delves into the patterns seen in human populations that are observable and recurring but not necessarily rational.
Trend-chasing is a biased investment approach in which investors use the past performance of an investment fund as a predictor of future growth. This is related to representativeness, the mindset that an investment can be considered objectively good or bad based on its recent performance. Both of these biased approaches lead investors to make an investment in a stock that is too high and may have reached the peak of its potential performance because they fail to take into account other market factors.
Familiarity bias is another related problem where people falsely attribute success or investment-worthiness to brands or funds that are known to them. They equate familiarity with investment growth potential, and fail to take into account that their familiarity is predicated on biased information such as proximity and visibility in one limited market. This can also be problematic in that investors fail to diversify and over-invest in local funds or funds in one sector because of familiarity, exposing themselves to undue risk.
Self-attribution bias leads investors to overemphasize their own influence on investment outcomes. They may be overconfident or exhibit magical thinking, where they believe themselves or their choices to be lucky, or conversely, they may develop a strong belief in a streak of bad luck, rather than recognizing external influences on investment success or having an objective view of their own decision-making and its impacts.
Herd behavior says that people tend to be influenced by the decisions of others and follow suit, exacerbating the effects of investment shifts, whether good or bad. If a moderate downturn is observed, then herd behavior may worsen it as people take notice and join in without any reference to objective assessments of the value and potential of the fund in question.
Proactive approaches to behavioral finance include learning the models, studying human behavior in general, and working with agencies, tools or other resources that include analysis of behavioral factors. You’ll want to start following markets update coverage that includes commentary on human behavioral impacts to gain a more informed understanding of the influences on investments and to hone the ability to improve your own investment choices. Sociopolitical and historical context can dramatically improve your ability to predict market movements and increase the value of your investments.
If you’ve been finding that the rational model of investment has been returning unexpected results, then behavioral finance may be the answer that you’re looking for, as it explores and codifies the irrational behavior of humans. Applying these models to your personal investment behavior, as well as using it to understand greater market movements, has the potential to revolutionize your investing experience.