By Molly Cyrus 
Introduction
Behavioural economics connects psychology and economics studying how psychological influences and emotional factors influence financial decision making. Conventional economic theories typically depict individuals as perfectly rational agents ever acting to their maximum advantage in a world of complete information.
Behavioural economics rejects this assumption as it introduces bounded rationality which states that people do not make the best possible choices but often rely on cognitive biases and heuristics among other psychological influences. Behavioural economics is very important in finance especially when significant investment decisions in terms of savings and risk come into play.
Investors traders and consumers often respond emotionally commit cognitive errors and are confronted with social pressures that cause them to act unreasonably. Understanding such behavioural tendencies provides very valuable insights into financial markets asset pricing and portfolio management. Key concepts in behavioural finance include cognitive biases heuristics and anomalies in the marketplace and then delve into their implications in making financial decisions.
Foundations of Behavioral Economics
Behavioural economics was born in response to the frailty of classical and neoclassical economics. What is considered decision making processes in real life goes far beyond the frames used by such models. Work truly meant to belong to the branch of behavioural economics was firstly the work of Daniel Kahneman and Amos Tversky around the 1970s particularly concerning prospect theory and cognitive biases.
Traditional Economics and Rationality
Traditional finance models rely upon the rationality of agents who seek decisions that maximise their utility. EMH and MPT are based on such concepts. EMH argues that as all available information goes into asset prices such security cannot be persistently beaten through any activity of stock picking or market timing.
However the real world observations of finance markets present phenomena like bubbles crashes and events of irrational exuberance as the basis of classical theory. In fact investors are not always rational or even partially rational. They could be more perfectly foresightful. Behavioural economics attempts to explain such anomalies by studying the impact of cognitive bias and emotional influence over decision making.
Bounded Rationality
The notion of bounded rationality introduced by Herbert Simon forms the backbone of behavioural economics. People are acknowledged as rational until they reach where they are possible yet frequently they cannot be perfectly rational because of a deficiency in knowledge and time pressure. An individual will be satisfied instead choosing an option that is good enough.
In finance bounded rationality has a variety of manifestations. Investors may make use of heuristics which are mental shortcuts that result in speedy decision making but lead to errors in judgement. An investor might invest in a familiar company even if it is not the best choice.
Cognitive Biases in Financial Decision Making
Cognitive biases are defined as systematic deviations from rationality when processing information with the view of making a decision. It can have a significant impact on financial decision making and often results in suboptimal investments.
Overconfidence Bias
Overconfidence bias refers to the tendency of an individual to overstate his abilities or the correctness of his knowledge. For instance in finance it can lead to over trading due to the impression that investors have better information or skills than those market indices.
Various studies have shown that overconfident investors have trading activities that are generally higher though at the cost of a loss in returns. Additionally overconfidence might even lead to risk underestimation due to the belief of having a lower loss probability.
Loss Aversion
One of the core concepts of prospect theory is loss aversion. People fear loss more than they like gain. That is an investor is more responsive to losses than gains of similar magnitude. That is sometimes investors hold onto losing investments hoping the loss will turn around with a little luck rather than realising the failure and channelling the capital to the proper investment thus irrationality springs in this scenario as well.
For example an investor may hold on to a losing stock for the reason that selling it will reflect a loss although selling is a more rational decision than investing the money elsewhere.
Anchoring Bias
Anchoring bias occurs when one bases decisions far too heavily on an initial piece of information the anchor. In finance investors may anchor their expectations of what a stock will do in the future based on where it has been even when there are obvious signs that market conditions have shifted.
Anchoring also occurs in the negotiation of mergers and acquisitions. In this case it is the form of an initial offer or valuation that acts as an anchor that can actually dictate subsequent negotiations.
Herding Behaviour
Herding behaviour is the phenomenon in which people are likely to imitate the actions of an even larger crowd instead of analysis or judgement. In finance herding has been attributed to bubbles and crashes. As investors collectively herd into rising asset prices as in the case of the dot com bubbles market valuations tend to inflate above their fundamental value. Conversely herding contributes to market panics and selloffs.
Mental Accounting
Mental accounting is the practice whereby people treat money differently because it comes from somewhere is being allocated for some purpose or is earmarked for a specific use. Investors might internally segregate their investments in an arbitrary set of accounts based on the definition of whether those investments are “safe” versus risky for example rather than viewing the portfolio as a single whole.
This bias can cause irrational investment decisions. For instance an investor might not like to sell a bad investment that is stored in their retirement account because in his head it is long term savings when the sale might boost total returns.
Heuristics and Financial Decision Making
Heuristics are shortcuts to the brain to simplify complex decisions. Though useful heuristics sometimes give birth to cognitive biases and judgement errors. There are different heuristics used in finance to make decisions.
Representativeness Heuristic
The representativeness heuristic makes people assess the probability of an event based on how well a typical case represents it. When applied in financial markets it makes investors assume that companies with externalities will have low stock price movements in the future because they are superficially similar to past trends.
For example he might make a bet that the growth rate of a company with technology is likely to be high because he reminds him of other companies in the category that have worked wonderfully in the past without paying attention to its fundamentals.
Availability Heuristic
The availability heuristic also results in people making choices based on the information that is readily available to them instead of making a deep analysis. In finance an investor can be influenced more by recent news or his experiences than by long term data or objective analysis.
For example an investor who just went through a market downturn most probably overestimates the prospects that the market has more downturns and will choose an overly conservative investment strategy even if the indicators of economic status show a stable or growing market.
Status Quo Bias
Status quo bias refers to the tendency of preferring things the way they are rather than changing them even when change may prove to be good for that particular individual. It leads people away from unnecessary changes in their lives. The status quo bias could lead investors to stick with suboptimal investment strategies or portfolios because they like the status quo.
A classic example is this retirement saving bias. Over time portfolio allocation has not changed despite changes in risk tolerance and financial goals.
Market Anomalies and Behavioural Finance
Market anomalies are departures from the traditional models of financial theory. These departures often arise due to behavioural factors that challenge the theory of the Efficient Market Hypothesis and assume that psychological influences can act as a cause of mispricing in financial markets.
Equity Premium Puzzle
The equity premium puzzle refers to the fact that stocks have historically provided much higher returns than bonds even though the difference in risk was always relatively modest. Traditional finance models cant easily explain it because rational investors ought not to require such a large premium in order to hold stocks.
The equity premium puzzle with behavioural economics can be explained using several reasons loss aversion and overconfidence. This will also ensure that investors receive a higher premium to help reduce the psychological pain of losing money in the stock market. Stocks should be outperforming bonds in the long run.
Momentum Effect
The momentum effect is the phenomenon whereby stocks that have recently performed exceptionally well will continue performing well in the short term and stocks that have underperformed in the past continue to do so. This contradicts the Efficient Market Hypothesis that postulates previous performance doesn’t make any difference in future returns.
Herding behaviour and overreaction of investors are herding behaviour and are some of the behavioural explanations of the momentum effect. Investors tend to join the bandwagon when they find a stock rising they also push the prices higher in such cases while panicking selling pushes prices lower in case of negative news.
The January Effect
The January effect is the market anomaly in which stocks mainly smallcap stocks tend to do better in January than in any other month of the year. Traditional finance theories do not really explain this sort of seasonal pattern but behavioural finance gives a number of possible explanations.
One of the reasons may be the tax loss sold by the investors to offset capital gains at year end which sends stock prices lower during December. Investors invest their money again in January and send the stock price back up again. Investor psychology is the other possible reason as people are relatively optimistic and not risk averse at the beginning of the year.
Behavioural finance has wider implications for investment strategies. Since behavioural finance deals with cognitive bias and emotional influences on decision making investors can use such knowledge in developing strategies to counteract these biases to attain better performance.
Contrarian Investing
Contrarian investing means going contrary to the prevailing market sentiment. While most investors may follow trends contrarian investors look for opportunities in such undervalued assets which due to some overreaction of markets are either overlooked or excessively sold off.
Behavioural finance supports contrarian investing by demonstrating how herding behaviour and overreaction to news leads to mispricing. Herding and overreaction have for example been shown to be aspects of finance theory in every issue of the Journal of Psychology and Finance. With such knowledge contrarian investors can take advantage of market inefficiencies.
Behavioural Portfolio Theory
It contrasts with MPT which provides one assumption that people are rational and risk averse and aim for maximal expected returns but accept only minimal levels of risk. Investors according to BPT instead chase a portfolio driven by dual goals such as loss aversion and achievement of specific financial objectives.
Using multiple layers within a behavioural portfolio allows investors to define different goals and make the decision whether higher risk or higher return investments must be placed in one or more sublayers of it. One layer may therefore create capital that only generates steady income while another allocates capital to higher risk higher return investments. In this way an investor is treated as less than completely rational taking into account emotional comfort over the ultimate financial outcome.
Nudge Theory in Finance
Nudge theory first initiated by Richard Thaler and Cass Sunstein conveys the necessity of how slight changes in the choice presentation can form a basis of behavioural influence without actually constraining freedom of choice. Nudges can thus be used in finance to improve one’s financial decision making.
For example auto enrolment into retirement savings plans proves to raise participation rates significantly because it is easier to enrol automatically than to optin manually. Also giving advice on finance and reminding investors in person may help keep investors on the right track towards their investment targets.
Behavioral Economics and Corporate Finance
Behavioural economics also has relevant implications for corporate finance including capital budgeting mergers and acquisitions and executive decision making.
Managerial Overconfidence
Managerial overconfidence is yet another bias in corporate finance where top level executives overestimate their ability to earn returns and make successful business decisions. Overconfidence can lead to excessive risk taking such as pursuing ambitious mergers and acquisitions or investing in speculative projects without proper due diligence.
Overconfident CEOs as such are more likely to engage in mergers and acquisitions at higher premiums and generate less postmerger returns. Thus recognizing and mitigating bias is pivotal in good corporate governance and value creation.
The Winner’s Curse
This is the winner’s curse one of the phenomena that often occurs in competitive bidding contexts including auctions or mergers and acquisitions. The phenomenon may be created when a winning bidder overpays for an asset although driven by various factors such as excessive confidence competition and less than perfect information.
The other behaviour in mergers and acquisitions is overpaying for targets because of fear of losing an opportunity or being fearful of the actual risks in their integration. Behavioural finance calls for firms to be careful of overbidding and advising that acquisition decisions should be based on analysis and not sentiments.
Behavioral Finance and Financial Regulation
Behavioural economics has influenced financial regulation particularly in areas such as consumer protection and market stability. For these regulators humans are not always rational so it might be necessary to protect them from predatory practices or excessive risk taking.
Market Bubbles Regulation
Behavioural finance may explain why there are asset bubbles whose prices increase very considerably beyond their intrinsic values following irrational exuberance herding behaviour and speculative trading. That knowledge may help regulators discover signs of warnings about bubbles and act appropriately to thwart such occurrences from happening.
In this case macroprudential policies can involve credit contraction along with more stringent lending standards provided by the central bank in order to cool overheating markets. In addition there is also increasing transparency and investor education that can help investors better understand and avert market mania.
Consumer Protection
It is in this light that regulatory approaches to consumer protection in the financial sector owe their development very much to behavioural economics. In effect regulators have observed that consumers often find it challenging to understand complex financial products and have come up with rules to increase disclosure simplicity and reduce information asymmetry.
For example the US Consumer Financial Protection Bureau has been focusing on making the disclosures for mortgages clear. Hence consumers are very well aware of the terms and the risks of such loans. Further rules have also been made to restrict predatory lending which exploits behavioural biases for example payday loans that charge really high rates of interest.
Conclusion
Behavioural finance would revolutionise our understanding of the nature of financial markets supposing that human behaviour is often not rational. Cognitive biases heuristics and emotional factors all dominate financial decision making and thus lead to anomalies mispricing and suboptimal investment strategies in markets.
By moving research into finance forward with insights from behavioural science investors policymakers and corporations can craft better ways to understand and manoeuvre the complex landscapes of the financial world. Incorporating behavioural finance into a personal investment can let people make more rational choices mitigate the influence of cognitive biases and achieve better long term results.
With respect to policymakers and regulators knowledge about psychological factors determining financial behaviour has generated stronger regulation and consumer protection measures. Indeed behavioural economics challenges conventional rationality in finance and presents a more beautiful form of understanding individual and market behaviour. With continuous evolution this field will provide insightful learnings on financial decision making market efficiency and economic stability improvement.