Behavioural financeexamines investor behaviour to understand how people make decisions, individually and collectively.
Behavioural finance does not assume that people consider all available information in decision-making and act rationally by maximising utility within budget constraints and updating expectations consistent with Bayes’ formula. The resulting behaviours may affect what is observed in the financial markets.
Loss Aversion
Risk aversion refers to the tendency of people to dislike risk and to require higher expected returns to compensate for exposure to additional risk. Behavioural finance allows for the possibility that the dissatisfaction resulting from a loss exceeds the satisfaction resulting from a gain of the same magnitude. Loss aversion refers to the tendency of people to dislike losses more than they like comparable gains. This results in a strong preference for avoiding losses as opposed to achieving gains.
Herding
Herding behaviour has been advanced as a possible explanation of under reaction and overreaction in financial markets. Herding occurs when investors trade on the same side of the market in the same securities, or when investors ignore their own private information and/or analysis and act as other investors do.
Overconfidence
A behavioural bias offered to explain pricing anomalies is overconfidence. If investors are overconfident, they overestimate their ability to process and interpret information about a security. Overconfident investors may not process information appropriately, and if there is a sufficient number of these investors, stocks will be mispriced.
Information Cascades
An information cascades is the transmission of information from those participants who act first and whose decisions influence the decisions of others. Those who are acting on the choices of others may be ignoring their own preferences in favor of imitating the choices of others. In particular, information cascades may occur with respect to the release of accounting information because accounting information may be difficult to interpret and may be noisy.
Other Behavioural Biases
Other behavioural biases that have been put forth to explain observed investor behaviour include the following:
- representativeness—investors assess new information and probabilities of outcomes based on similarity to the current state or to a familiar classification;
- mental accounting—investors keep track of the gains and losses for different investments in separate mental accounts and treat those accounts differently;
- conservatism—investors tend to be slow to react to new information and continue to maintain their prior views or forecasts; and
- narrow framing—investors focus on issues in isolation and respond to the issues based on how the issues are posed.
Behavioural Finance and Investors
Behaviour biases can affect all market participants, from the novice investor to the most experienced investment manager. An understanding of behavioural finance can help market participants recognise their own and others’ behavioural biases. As a result of this recognition, they may be able to respond and make improved decisions, individually and collectively.
Behavioural Finance and Efficient Markets
The use of behavioural finance to explain observed pricing is an important part of the understanding of how markets function and how prices are determined. Whether there is a behavioural explanation for market anomalies remains a debate. Pricing anomalies are continually being uncovered, and then statistical and behavioural explanations are offered to explain these anomalies.
