Behavioral finance definitions

Plan of the whole chapter

See also

Introduction
(= this page)

Main concepts: BF vs. EMH [see also
abstract
(slides)]

Behavioral-Finance Gallery

500+ keywords BF glossary and

1700+ members informative BF forum


Part A

Individual and social behavioral biases

Part B

Economic and financial incidences

separ

Introduction & main concepts: BF vs. EMH

  Behavioral finance vs. EMH, RWH

(See more details below: what produces stock quotes)

What is Behavioral finance?

It can be defined as the role of psychology in money matters, and a
more narrowly as the study of
how investor psychology influence
prices and returns in asset markets
.

There are two (complementary) main schools of Behavioral Finance:

* BF micro (investor psychology),
   aka "Psychological behavioral finance"

* BF macro (market effects),
   aka "Quantitative behavioral finance"

BF and BE

Behavioral finance has also branched out into BE-
Behavioral economics,

BE studies a wider set of phenomena,
although largely
fed by behavioral finance researches and findings.

BF and EMH / RWH

Behavioral Finance, chiefly in its macro form, can also be defined as
an approach of finance that takes its distance from the "standard
finance", which was
for decades the common paradigm based on
the EMH / efficient market hypothesis;

There are also several schools of EMH and various forms of
efficiencies (see our Behavioral-Finance Glossary).

Their common approach is that, in large and free markets, the market
price
of an item:

is its only possible price, to which demands and offers naturally
  converge,

reflects all available information and thus is the best estimate of its
  value

doesn't leave any arbitrage opportunity, as prices stay in a stable
  equilibrium in the lack
of new events / information, and change
  quickly and
correctly to a new equilibrium every time new
  information rings at the gate.

The EMH supposes therefore, as those new information / events
happen at random, that prices and returns evolve randomly
(RWH / random walk hypothesis)

Behavioral finance and market anomalies

The EMH is just a theory and markets are not completely efficient.

Research has found that they show anomalies / inefficiencies
in prices and returns
.

We mentioned above that even the defenders of EMH see several forms
of efficiency
.

But the ambiguity goes further as, in reality:

* Markets have only some degree of efficiency.

* Also, they are less efficient in the short term than in the long term.

Those findings have led to the creation of that new approach of finance:
"Behavioral Finance" (BF).


Psychologists, such as Daniel Kahneman, contributed to this new body
of knowledge.

BF applies psychology research to finance.


It studies
market inefficiencies / anomalies, distortions,
and the behavioral biases / errors that contribute to them.

People, and among them investors, are not totally "rational".

Specifically when they are facing a "decision under risk and uncertainty",
which is often the case in financial and economics matters.

Their decisions might not match exactly their " utility", a concept that
is one of the bases of economic theory.

Such decisions are often shallow-based (heuristic) and/or "under influence"
(anchoring, groupthink).

This irrationality / bounded rationality, those cognitive / emotional biases
and decision-making anomalies create:

1) Individual investment mistakes, sources of insufficient returns or

      excessive risk-taking for a given investor.

2) Collective biases.

Above a critical threshold / mass (see dynamical systems) of
similar individual
behavior, a fast "contagion" takes place and
individual
phenomena turn into collective ones.

3) General market inefficiencies, such as mispricing or return
       anomalies between
various assets, periods, etc.

BF tries to detect and understand those biases & anomalies, those
       phenomena
that differ from what the EMH states, and if possible to
       use them in investment strategies.

Main investor biases / errors

What are psychological blunders people do in stock markets,
as well individually as when following the crowd?


  Individual biases

(financial psychology)

Collective biases

(fin. sociopsychology)

Cognitive

biases

 

 


 

 

Anchoring, attention bias, attribution,
belief, cognitive
overcharge, cognitive
dissonance, fallacy, framing,
generalization, habit, halo, hindsight
bias, home bias, (availability,
representativeness) heuristic,
irrationality, mental accounts,
reductionism, representation,
selective attention, small numbers,
stereotype.

Cascade, common belief,
consensus, cultural
bias,
groupthink, manipulation,
meme, mimicry, paradigm,
percolation, rational
expectations (positive
feedback), social learning,
social convention


Emotional

biases

 


 

Affect heuristic, commitment, denial,
greed, fear, hope,
(loss / risk,
uncertainty, regret aversion,
endowment effect, emotion, feeling,
house money, magical thinking,
optimistic bias, overconfidence, pain,
pleasure, pride, sentiment, status
quo bias, time horizon, wealth effect.

Bandwagon, conformity,
epidemics, deification /
demonization, fads, herding,
gullibility, mimicry, home
bias, peer pressure, social
mood, market sentiment,
trust.


Autopilot
bias

Addiction, habit, reflex

Rules, social codes and rites

Segmentation of market agents

(typologies of trading strategies / styles / tools)

Types

Examples

Types of strategies

Noise trading vs. long term investing.

Value investing vs. growth investing....

Types of attitudes

Risk averse / tolerant / seeker.

Active / passive. Aggressive / conservative

"Economic data"
  users

FA (intrinsic data): comparing market
prices and economic value

"Market data"
  users

TA, QA (finding patterns in recent market
evolutions),
timing, momentum trading,

"Behavioral tools"
  users

BA, image coefficient, underreaction /
overreaction

Main kinds of market distortions

The main distortion (anomalies / inefficiencies) from the "fair values"
and "efficient returns" can be spotted in:

Image, perception,
representation,
that create
a premium or discount.

(as seen in the previous page:
stockprofiling
): stock families,
image ranges and evolutions

Reactions (to signals /
information),
that bring excessive
or insufficient price raises or falls.

Underreaction, overreaction:
momentum,trends, cascades,
bubbles, crashes
, rotation

What produces stock quotes?

General economic prospects?
The company's prospects?

Those are the ideas that come to mind when that question
is asked.

Hey, just a minute, are not prices made by zillions of investors' decisions to
buy, sell, hold or stay aside? In that case:

Even if, in theory, the expected rewards from a stock depend on
those prospects.

They are often taken in a rush, or on the contrary too late.

And from information investors don't always obtain or understand.

When you buy a suit you like, do you check first if you get your money's
worth as regards the fabric's durability?
And if you buy a car, is its annual budget your main criterion? Between you
and me, who really estimates it?
Which car owner has more than a vague idea about it?

Maybe only 10-15% of people might give a frank and definitive yes answer
to such questions in normal times, and maybe a few more in gloomy periods.

Precisely, Behavioral Finance (BF) studies how individual and collective
behaviors influence market prices.

What plays a part here is that people in general, and investors in particular,
are not fully "rational" in their decisions. They are "under influence".

=> Thus, BF deals mostly with investor irrationality / bounded rationality /
     
cognitive and decision biases.

Those biases create market inefficiencies, in the shape of mispricings.

They are deviations between the real stock prices and the so-called stock
"intrinsic values" calculated with traditional mathematical models.

This leads to anomalous returns.

Behavioral financial) Analysis (BA - BFA), the practical arm of BF,
analyses those  price and return anomalies and their causes.

It uses tools like image calculation, consensus polls, etc. (see below),
hoping to take advantage of them to assess risks and potential gains.

This goes (even if it takes advantage of them) against traditional pricing
models, based on the EMH / efficient market hypothesis.

Unluckily, the EMH does not fit well market realities, even if some
"degree of efficiency" may exist.

So, what is the EMH?

The EMH (let us spare the details about the strong, semi strong and
weak of the EMH that can be found in Leif's Ericssen analysis and
in the BF glossary, is the belief that:

People (or at least the dominant players) are fully
  informed and interpret correctly public and private
  information.

They are rational, and thus maximize their financial
   utility.

There is independence across individuals (no imitation
   between them).

Their decisions lead to a price equilibrium (efficient
  price, rather stable in the absence of new information).

All in all, the EMH considers that the market's pricing of an item,
thus for a stock its current market price:

  is the best estimate of its value

  is the exact and full reflection of all available
   information

  changes immediately and correctly with
   every new information.

For a given stock, the EMH supposes everyone knows all the
facts, uses them independently, and makes a time discounting
for projected earnings to arrive at:

Ideally, the same price.

Or a bracket of individual estimated prices due to each
  one's utility coefficient (individual sensitivity to gain /
  risk prospects).

This range of buying / selling proposals will create a
stable
supply / demand balance (in the absence of
new meaningful information) in the market, with a stable
price.


A (false?) cousin of the EMH: the RWH

The RWH, random walk hypothesis states that " prices have no memory
and yesterday is unrelated to tomorrow".

The underlying theory is that past prices records cannot help to predict future
prices or to time the market.

The many competing participants acting at various times should make the
price wander randomly around its equilibrium level
(*).

This optimal level would change over time, randomly again, in response to
new information as it sporadically shows up.

Some consider the RWH unfit to describe dynamical systems (mentioned
above) and prefer the fractal walk / chaos-determinist walk concept .

This gives the appearance of randomness, and also the appearance of an
efficient market, but does not actually warrant efficient pricing and returns.

(*) actually, even if markets are biased by individual behaviors, it could
     happen that
those cancel out and that the prices evolution follows a
     random-like
pattern. But this is less possible when collective biases are
     at work.

And now, let us see the details of investor biases
    and market anomalies

Four main types of behavioral phenomena are sources of
mispricings, as shown in Part A:

1

Individual understanding, recalling and reasoning
anomalies (cognitive biases)

2

Collective cognitive biases / errors (affecting the whole
market or dominant types of investors)

3

Individual emotions / passions leading to biased
judgments and behavior distortions

4

Social psychology (group and crowd behaviors),
collective emotions / hysterias / manias

NC

(Physical or institutional) autopilot biases

5

In practice: precautions for investors

We will deal also with more general or complementary (or more
practical) topics, as shown in Part B:

5

Behavior of the market itself (anomalies in price, volumes,
volatility...)

6

Behavioral assets pricing / risk assessing methods...

7

Probabilities, utility, game theory, experimental finance
and other aspects

8

The limitations of BF

 

Not to forget that you can find the full definition of every phenomenon
(500 keywords) in the Behavioral-Finance Gallery


Other sections of the chapter

See also

Part A

Individual and social behavioral
biases

Behavioral-Finance Gallery

500+ keywords BF glossary and

1700+ members BF forum

Part B

Economic / financial incidences

separ

   This page last update: 24/04/15       Previous page [behav.fin]    Next page[Part A]
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