What Does Behavioral Finance Mean?
When you hear the term “behavioral finance” it may be confusing for some and is often misunderstood by others. In general, behavioral finance is a subcategory of behavioral economics, which describes the psychological persuasion and biases that investors and financial professionals have, which alter their financial behaviors. The influences and biases are a source of explanation for many types of market peculiarities and certain market oddities in the stock market, such as drastic rises or falls in stock price.
Behavioral Finance Explained
Behavioral finance can be broken down into a variety of perspectives. Returns on the stock market are a major area of finance where psychological behaviors influence the market outcomes and returns. The reason for the classification of behavioral finance is to help explain why people make certain financial decisions and how those decisions affect the markets. When dealing with behavioral finance, it is often thought that financial contributors are not always logical and sensible but often psychologically influenced by normal and self-controlling tendencies.
Mental and physical health play a major role in financial health. When you are physically and mentally healthy, you tend to make responsible decisions for your finances which then allows you to have positive financial health. The same goes for if you are mentally and physically unhealthy. You may make irrational decisions financially due to your mental and physical unhealthiness which can negatively affect your financial health. Stress plays a major role in the
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the physical and mental health of an investor making financial decisions. While this is not the case for everyone, it can be a contributing factor to your finances.
Behavioral Finance Terms
• Mental accounting: Mental accounting is the ability for people to dedicate money for specific purposes. An example of this is budgeting
• Herd behavior: Herd behavior is the tendency for people to copy the financial behaviors of much of the herd. An example of this is a bandwagon
• Emotional gap: Emotional gap is when people make decisions based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Emotions are a major reason why people do not make sensible choices.
• Anchoring: Anchoring is when people attach a spending level or dollar amount to a certain task. An example is spending a certain amount based on a budget level or rationalizing spending on certain satisfaction levels.
• Self-attribution: Self-attribution is when people tend to make decisions based on the confidence of their knowledge or skill. An example is betting based on prior knowledge or skills.
Biases of Behavioral Finance
Confirmation bias is when an investor has a bias that confirms their preconceived belief in an investment. If information backs their bias, the investor confirms their belief about their investment decision—even if the information is false.
An experiential bias is when a memory or recent event makes the investor biased or leads them to believe that an event is more than likely to occur again. An example of this was the stock market crash in 2008 and 2009. Many investors withdrew from the stock market. Many people had a negative view of the markets and thought there was more economic hardship in years to come. That was not the case. A couple of years later the economy recovered, and the market bounced back.
Loss aversion is when investors put a greater weighting on their concern for losses rather than the satisfaction of gains from the market. The investor is more likely to have a higher priority in avoiding losses than making investment gains. If this is the case, some investors tend to buy more conservative stocks and stay away from investing in aggressive stocks that are subject to a higher reward but also a higher risk.
Familiarity bias is when someone invests in what they know, such as popular companies or have locally owned investments. Within this bias, investors are usually not diversified across multiple sectors and typically only have one certain type of investment. People tend to invest in what they have a history or familiarity with.
What to Learn From Behavioral Finance?
Behavioral finance lets us learn and understand how financial decisions such as investments, payments, risk, and debt are influenced and manipulated by emotions, biases, and intelligible limitations of our minds in processing and responding to what we learn.
How to use Behavioral Finance to Help you?
By learning how, when, and why people diverge from rational expectations, behavioral finance lays out a map to help make smarter, more rational decisions when financial decisions arise. It also helps you see where your personal thoughts are coming from and where your decisions let you end up.
Disclosure
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of (Paul D. Snow ) and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.