Behavioral finance, a sub-field of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source for explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price.
It is an innovative approach complementary to the traditional and descriptive one. It does not assume that individuals are rational but explains the mistakes we tend to make and how to correct them.
Within behavioural finance it is assumed that the information structure and characteristics of market participants systematically influence individuals’ investment decisions.
Behavioral finance first appears in the neoclassical economics thanks to Adam Smith with his book Theory of Moral Feelings described the functioning of individual psychological behavior and Jeremy Bentham with his text based on the psychology of utility. After having disappeared from economic thought for over half a century, behavioural economics knew a new birth in the economics studies around the 1960s. Through the development of cognitive psychology economic models of rational behaviour merge with cognitive models linked to the decision-making process.In the last fifteen years, three Nobel prizes have been awarded for a work on behavioral finance the psycologist Daniel Kahneman and the economists Richard Thaler and Robert Shiller.
Most economic theories, for example EMH (efficient market hypothesis), are based on the idea that act of individuals within markets is rational. However when anomalies such as speculative bubbles occur within the market the investor’s behaviour is not only due to information asymmetries or the failure of efficient market theory, as standard finance stated, but also to irrational behaviour influenced by strong emotions. Behavioural Finance offers a more realistic and humane interpretation of how financial markets work.
Behavioural errors can be cognitive or emotional. Cognitive errors involve our way of reasoning, emotional ones are dictated by emotions.
Loss aversion is one of the most common cognitive error. It is the attitude of the individual in the treatment of losses versus gains. In other words the fear of losing 1 € is higher than the joy of gaining one. This results in a heavier weighting of losses affecting the investment risk. For this reason have developed a different way of considering and calculating risk creating valuation models that take into account this asymmetry.
Another cognitive error is called home bias. It consists in the investors’ attitude to invest in domestic securities rather than foreign ones. This is due to the fact that the human mind tends to prefer solutions recognized as familiar and notorious, this leads investors to disregard the diversification benefit generated by foreign securities.
Overconfidence is the predisposition of a cognitive error that refers to one’s abilities and awareness of one’s own limits; is a full part of the behavioural traps. This condition can prove to be risky in an investment choice. Forecasts are often wrong because they are based on few and superficial elements such as commonplaces, memories and external reference points.
Beside these cognitive errors we make many emotional mistakes such as being optimistic and euphoric when markets go well and panic when markets go bad. This leads us to do the opposite of what we should do: in the first case prices rise and we should be more cautious, but the emotional aspect leads us to buy. In the second case prices fall and we should evaluate opportunities to buy, but fear leads us to sell.