Behavioral finance definitions
Plan of the whole chapter
(= this page)
Main concepts: BF vs. EMH [see also
500+ keywords BF glossary and
1700+ members informative BF forum
Individual and social behavioral biases
Economic and financial incidences
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-
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
reflects all available information and thus is the best estimate of its
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
Research has found that they show
anomalies / inefficiencies
in prices and returns.
We mentioned above that even the defenders of EMH
see several forms
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
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"
This irrationality / bounded rationality, those cognitive / emotional
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?
Anchoring, attention bias, attribution,
belief, cognitive overcharge, cognitive
dissonance, fallacy, framing,
generalization, habit, halo, hindsight
bias, home bias, (availability,
irrationality, mental accounts,
selective attention, small numbers,
Cascade, common belief,
consensus, cultural bias,
meme, mimicry, paradigm,
feedback), social learning,
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.
epidemics, deification /
demonization, fads, herding,
gullibility, mimicry, home
bias, peer pressure, social
mood, market sentiment,
Addiction, habit, reflex
Rules, social codes and rites
Segmentation of market agents
(typologies of trading strategies / styles / tools)
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
FA (intrinsic data): comparing market
prices and economic value
TA, QA (finding patterns in recent market
evolutions), timing, momentum trading,
BA, image coefficient, underreaction /
Main kinds of market distortions
The main distortion (anomalies / inefficiencies) from the "fair values"
and "efficient returns" can be spotted in:
(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.
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
Hey, just a minute, are not prices made by zillions of investors' decisions to
buy, sell, hold or stay aside? In that case:
How do you know that economic prospects are always involved?
Even so, why those decisions should reflect exactly 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?
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.
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
They are rational, and thus maximize their financial
There is independence across individuals (no imitation
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
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 /
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
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
happen that those cancel out and that the prices evolution follows a
random-like pattern. But this is less possible when collective biases are
And now, let us see the details of investor biases
Four main types of behavioral phenomena are sources of
mispricings, as shown in Part A:
Individual understanding, recalling and reasoning
anomalies (cognitive biases)
Collective cognitive biases / errors (affecting the whole
market or dominant types of investors)
Individual emotions / passions leading to biased
judgments and behavior distortions
Social psychology (group and crowd behaviors),
collective emotions / hysterias / manias
(Physical or institutional) autopilot biases
In practice: precautions for investors
We will deal also with more general or complementary (or more
practical) topics, as shown in Part B:
Behavior of the market itself (anomalies in price, volumes,
Behavioral assets pricing / risk assessing methods...
Probabilities, utility, game theory, experimental finance
and other aspects
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
Individual and social behavioral
500+ keywords BF glossary and
1700+ members BF forum
Economic / financial incidences