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 1800+ members informative BF forum
Part A	Individual and social behavioral biases
Part B	Economic and financial incidences

Introduction & main concepts: BF vs. EMH

(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 bit 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 Behavioral economics (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 based on the EMH / efficient market hypothesis has been for decades the common paradigm.

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 absence of new information,

and change quickly and correctly to a new equilibrium each 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)

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 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.

What kind of psychological blunders people do in the stock exchange, individually and as a crowd?
	Individual biases (financial psychology)	Collective biases (financial sociopsychology)
Cognitive biases	Anchoring, attention bias, attribution, belief, cognitive overcharge, cognitive dissonance, fallacy, framing, generalization, habit, halo effect, 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,
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 and rites

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

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: moùentum, trends, cascades, bubbles, crashes, rotation

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:

• How do you know that economic prospects are always involved in that? Even if, in theory, the expected rewards from a stock depend on those prospects.

• 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 that 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 totally "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.

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 each time there is 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 for dynamic systems and prefer the fractal walk /chaos-determinist walk concept (see below).

This gives the appearance of randomness, and also the appearance of an efficient market, but it does not actually guarantee 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.

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 1800+ members informative BF forum
Part B	Economic and financial incidences

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