Behavioral finance is a new area of financial research that explores the psychological factors affecting investment decisions. It attempts to explain market anomalies and other market activity that is not explained by the efficient market hypothesis.
The fundamental basis of behavioral finance is that psychological factors, or behavioral biases, affect investors, which limits and distorts their information and may cause them to reach incorrect conclusions even if the information is correct. Hence, behavioral finance could be considered a subset of behavioral economics, which explores the basis of decision-making.
Behavioral biases can be categorized in many ways, and many of these categories may be overlapping or indistinguishable. The following factors have been published as having some impact on the market. Contrarian and momentum strategies take advantage of some of these psychological factors.
Emotion often overrules intelligence in decisions and can filter facts, where the investor may give too much weight to agreeable facts and may ignore or underweight disagreeable facts, often called confirmation bias.
There is the fear of regret, or regret avoidance, which causes investors to hold losing positions too long in the hope that they will become profitable or sell winners too soon to lock in profits lest they turn into losses.
Overconfidence in one's abilities can lead to higher portfolio turnover and to lower returns. Despite the fact that few investors or even professional portfolio managers beat the market over an extended time, there is still considerable active portfolio management. One study has shown, on average, that men have lower returns than women because they trade more actively, presumably because they have greater confidence in their abilities.
Conservatism is the hesitation of many investors to act on new information, where such information should dictate an action or a change to one's strategy. This hesitation to news, for instance, eventually leads to action at different times for different investors, leading to momentum as more investors start reacting to the news.
Belief perseverance is the persistence of one's selection process and investment strategies even when such strategies are failing or are suboptimal, causing the investors to ignore new information that may contradict one's decisions.
Loss aversion is the propensity for people to avoid losses even for possible gains. Hence, people often hang onto losing stocks longer than they should, since selling would actualize the loss; otherwise, it is still just a "paper loss". Loss aversion is related to the marginal utility of money, where the 1st dollars are more valuable than additional dollars. For instance, most investors would avoid an investment where there was a 50% chance of either earning $50,000 on a $100,000 investment, or an equal chance of losing the same amount, because the $50,000 lost would have greater marginal utility, and, therefore, would have greater value to the investor, than the $50,000 potentially gained.
Misinformation and Decision-Making Errors
Misinformation and decision-making errors probably account for most market inefficiencies, since no one knows everything and, even if they did, they may not make the best decisions based on that information.
Forecasting errors are a typical example, since even stock analysts are frequently wrong about future earnings and prospects for the companies that they cover.
Representativeness is the extrapolation of future results based on a limited set of observations or facts; hence, this is sometimes known as small sample neglect. This is best illustrated by investors seeking a fund in which to invest, basing their decision on the fund's most recent performance rather than covering a longer duration that also included bear markets. Often, this is the result of the lack of due diligence, where the investor relies on brochures or other advertising materials put out by the company or fund instead of doing independent research.
Narrow framing is the evaluation of too few factors that may affect an investment. For instance, an investor may buy a security because of its past performance without considering economic factors that may be changing that could change the performance of the security. Mental accounting is a specific kind of narrow framing in which different investments are mentally segregated, applying different criteria and due diligence to each account, where the different treatment may be unwarranted. For example, treating separate investments as if they were the only investment rather than as part of one's portfolio.
Biased decision-making and information-gathering is the distortion of personal bias on facts and thinking to conform with one's current opinions or actions.
Limits to Arbitrage
So if behavioral bias misprices stocks, why don't arbitrageurs take advantage of the mispricing, by buying and selling until the mispriced stocks equal their intrinsic value? Behavioral advocates have argued that mispricing persists because there are limits to arbitrage.
First, there is the risk that the mispricing will get worse, and, therefore, present a risk to arbitraging. The market influence of behavioral bias may exceed the influence of arbitrageurs, especially since arbitraging behavioral bias is not risk-free. And even if prices do trend toward their intrinsic prices, it may take longer than arbitrageurs think — maybe longer than their investment horizon.
Secondly, financial models may be inaccurate, making arbitrage risky.
Thirdly, much of the arbitrage activity would require short selling, which, with stocks, is very risky, and many institutional investors are not permitted to sell short.
Can Behavioral Bias Explain Market Anomalies?
Possibly, but there has been no connection of cause to effect. The problem with behavioral finance is that it is too general, too murky. Virtually any market anomaly can be explained by selecting whatever reasons that seem plausible. But this doesn't establish cause and effect. In fact, many things that seem reasonable are wrong.
The biggest critique of behavioral finance is that it is more of a philosophy than an actual science, since there are few, if any, controlled experiments to verify cause to effect. And even if there were such experiments, they probably wouldn't be useful for investors since it would be almost impossible to quantify these factors, not only for an individual, but certainly for the investing population, and using statistics would not yield precise enough results to be useful for investors. Not even institutional portfolio managers with high-speed computers and sophisticated financial models can predict the markets, for if they could, most of them would be outperforming the indexes, and, yet, many studies have shown that they rarely do over an extended time, and even the ones that do may do so out of pure chance. After all, when thousands of portfolio managers are trying to outperform the market, some, like the proverbial monkeys throwing darts on a stock board, will succeed simply because of luck.
The Largest Behavioral Factor: Lack of Information
No doubt behavioral bias does explain much of the market activity. However, I believe that the biggest factor in behavioral finance is simply the lack of information. Because financial markets are so complex, no one can even know all the relevant factors that explain its activity, let alone quantify those factors to arrive at an accurate forecast. Moreover, different investors will have different information, and will have a different reaction to that information than others. Even to say that a stock is mispriced is an opinion — what is the true price of a stock? Many would say its intrinsic value, but intrinsic value depends on the present value of the stock's future cash flows. To know the present value of future cash flows, you need to know the capitalization rate the market is using to discount those cash flows, then you need to know what those cash flows will be, including dividends and the stock sale price. Since no one can know these things with certainty, intrinsic value is only an opinion as to what it should be, and different investors will have a different opinion. Furthermore, the opinions of any individual investor will change over time as new information is gained.
Markets may be rational if every factor that affects them could be known and quantified, but that isn't possible. How do you explain the stock market bubble in the late 1990's. Irrational exuberance — is that another behavioral bias? No doubt. After all, the market was rising so fast and high, that people thought that it would just continue, just as they thought about real estate prices a few years afterwards, before the real estate bubble finally collapsed in 2007. Obviously, in these cases, people were buying because they thought the market would continue its trend and that they would get out just before it fell. In other words, they were buying because of what they were expecting the market to do, not on what individual stock prices should be.
As I sit here, writing this in early January, 2009, the stock market is still sitting near its nadir since December, 2008, and yet, even though the market has dropped about 40% in 2008, with most stock prices much less than they were in 2007, nobody is rushing in to buy at these depressed prices. Why not? Shouldn't the arbitrageurs be rushing in, buying stocks at a frenzied pace, until the stocks reached their "true price"? The limits to arbitrage were listed earlier, but those limits don't apply here. For instance, it seems almost certain that prices will not go much lower than they are now. Secondly, regardless of what financial model you use, stocks are much better bargains now than they were in 2007. Thirdly, since prices are depressed, only buying is needed to bring those prices back to their "proper level". No short selling is needed. And, yet — few arbitrageurs are taking advantage of these bargain prices — at least not enough to raise them quickly. Anyone buying now can probably earn abnormal returns, since the market will almost certainly go up from here — albeit, slowly.
The main problem in researching behavioral finance is linking cause to effect. While the psychological basis of many investment decisions can be explained by principles that seem reasonable, there is no hard evidence that such principles actually explain the events studied. There are few studies that study, in detail, individual investors, to discover the link between their motivations and their investment decisions.
A good example of this rational attribution to specific causes is the daily reporting of news. Regardless of what the markets do, or what individual stocks do, their activity is "explained" by the reporters as being due to this or that. The explanations sound reasonable because the reporters select what seems rational to them, then look no further for anything that might contradict their explanation. If the market is up, they select reasons why it is up, and if it is down, then they select different reasons that "explain" the market decline. But there is little reason to believe that the proffered explanations have validity. After all, it is reasonable to assume that the markets will always do something even if there was no news at all, which is why they exhibit the random walk.
While there is no doubt that behavioral bias does affect the markets significantly, it has little use in forecasting the markets, since the many facets of human behavior cannot be quantified, and it will not enable the individual investor to earn abnormal returns based on its tenets.