Behavioral Finance vs. Traditional Finance: 3 Surprising Ways Human Behavior Can Make or Break Your Investments

Behavioral Finance vs. Traditional Finance: 3 Surprising Ways Human Behavior Can Make or Break Your Investments

Traditional finance is like that straight-A student who insists that 2+2 always equals 4. Traditionalists believe that investors consistently make decisions based on the expected value of outcomes, with equal weighting of gains and losses. They assume that individuals evaluate choices objectively, irrespective of how they are framed. It’s built on a few key principles:

1. Rationality: Investors are as rational as Spock from Star Trek, always making logical decisions.
2. Market Efficiency: Markets are all-knowing entities, quickly absorbing information and reflecting it in stock prices. It’s like having Google in your stock market.
3. Risk and Return: The greater the risk, the greater the potential return. It’s like opting for a double espresso instead of a regular coffee, expecting a bigger caffeine kick.
4. Diversification: Don’t put all your eggs in one basket. Spread your investments like you spread butter on toast – evenly

Enter Behavioral Finance: Human Quirks at Play

Behavioral Finance saunters in and says, “Humans? Rational? Have you met one?” It focuses on how psychological influences and emotional responses impact investment decisions. Key principles include:

1. Irrational Exuberance / Sentiments Sometimes, investors get overly excited and inflate market bubbles like they’re at a bubble-blowing contest.
2. Heuristics and Biases: These are mental shortcuts and quirks. For example, “anchoring” – when investors fixate on specific price points like a ship anchors at sea.
3. Prospect Theory: People hate losing more than they love winning. It’s like eating a cookie – the joy of getting one is less than the sorrow of losing it

Irrational Exuberance/ Sentiments :

In the high-stakes world of trading, ‘Irrational Exuberance’ often plays a pivotal role, leading traders to make overly optimistic decisions disconnected from fundamental market realities. Coined by former Federal Reserve Chairman Alan Greenspan, the term describes the unfounded market optimism that can inflate asset prices and create bubbles. Traders, caught in this wave of enthusiasm, may ignore warning signs, driven by herd behavior and a fear of missing out. This phenomenon has historically led to significant market corrections, serving as a reminder of the importance of balanced, informed decision-making in the volatile realm of trading.

What are Heuristics and Biases?

Heuristics are cognitive shortcuts or rules of thumb that simplify decision-making. They’re mental strategies developed through experience, helping us to quickly size up a situation and act without needing to ponder every possible outcome. However, these shortcuts can lead to biases – systematic errors in thinking and judgment.

Types of Heuristics and Biases

1. Availability Heuristic

The availability heuristic is a cognitive shortcut where we gauge the likelihood or risk of an event by how readily we can recall relevant examples. If we can easily recall numerous instances, we tend to perceive it as occurring frequently.

Examples :

• When you start seeing news reports about folks losing their jobs, it’s natural to start feeling like your own job might be on shaky ground. Suddenly, you’re lying awake in bed every night, consumed by worry, thinking you might be the next one to face a pink slip.
• While COVID-related deaths are certainly concerning, it’s worth noting that mosquito bites actually result in more fatalities each year than COVID.

2. Anchoring Bias

Anchoring bias is when you too heavily on the first piece of information we receive. In negotiations, the first price offered often sets the stage for the rest of the discussion, impacting the final agreement more than it should.

Example :

You buy shares of company xyz at $ 80 per share

Currently the stock is trading at $ 120

Stock Starts to decline to $ 100 due to change in certain fundamentals

You delay selling the stock at $ 100 thinking that it will bounce back to $ 120

Eventually the stock is now at $ 40.

Here Anchor Bias is influencing your decisions

3. Confirmation Bias

Confirmation bias is like wearing glasses that only let you see what you already believe. So, if you think a certain stock is a great investment, you’ll pay attention to news that agrees with you and forget about anything that disagrees. This habit makes it tough to make fair decisions because you’re only looking at part of the picture and ignoring the rest.

Example : 

You keep holding onto the poor-performing stock you have, even when the facts and numbers are against you, simply because you believe in it.

4. Overconfidence Bias

Overconfidence leads us to overestimate our knowledge, ability, or the accuracy of our predictions. This bias can result in significant financial losses and poor strategic decisions.

Example :

An individual investor might have a handful of stocks they believe will outperform the market and allocate significant portion of the portofolio

5. Loss Aversion

A key concept in behavioral economics, loss aversion refers to our tendency to prefer avoiding losses to acquiring equivalent gains. It’s the idea that losing $100 feels more painful than winning $100 feels good. This bias can lead to overly conservative behavior in investing or an unwillingness to cut losses in a declining market.

“Awareness is the first step in mitigating the effects of heuristics and biases. Critical thinking, seeking diverse perspectives, and adopting structured decision-making processes can help counteract these cognitive traps “

Prospect Theory:

It was developed by Daniel Kahneman and Amos Tversky in 1979, Prospect Theory revolutionized our understanding of decision-making under risk. Traditional economic theory assumed rational actors who would weigh gains and losses equally. Kahneman and Tversky, through ingenious experiments, showed that this isn’t how real people behave. Instead, you need to have an inbuilt aversion to loss, often irrationally overvaluing what we possess compared to what we might gain.

The Balancing Act: Using Both Approaches

The truth is, both theories have their dance at the ball. A savvy investor uses traditional finance as a map but checks the behavioral finance compass to understand the human terrain.

1. Use Traditional Models, But Stay Alert: Employ traditional models for valuation but be aware of market sentiments and investor psychology.
2. Understand Your Biases: Know thyself. Are you prone to follow the herd? Do you overreact to bad news?
3. Diversify, But Also Personalize: Diversify your portfolio, but also consider your risk tolerance and investment goals, which might be influenced by personal experiences and emotions.

Remember friends , finance is not just about numbers and charts. It’s a human drama, full of rational decisions, emotional reactions, and everything in between. Whether you lean towards the calculated world of traditional finance or embrace the human-centric view of behavioral finance, understanding both will make you a more rounded, and perhaps, a more amused investor.

I believe you enjoyed reading this article.

A comment on what you think would be motivating to write more.

Thanks

Regards

Srikanth