Main behavioral finance concepts


pi-arrig.gif (1666 octets) Behavioral finance (BF) as opposed to EMH

Behavioral Finance (BF) is the application of psychological 

research to finance.

It studies how investors, borrowers... make their decisions.

 

Its findings differ from the

EMH / efficient market hypothesis,

which was for decades the standard paradigm.

 

BF research shows that financial markets are not

fully efficient:

* There are anomalies of prices and returns.

* They are due to investors' mental biases.

 

=> BF studies those anomalies and biases.


pi-arrig.gif (1666 octets) The previous paradigms: EMH, RWH

The EMH have several versions (strong, semi-strong,

weak).

But basically that theory claims that, in large and free
markets, an item's market price

* is its only possible price,

* reflects exactly and fully all available information,

* 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 every time new information arrive.

 

As those new information / events happen at random,

prices and returns are supposed to  evolve randomly

(RWH / random walk hypothesis)


pi-arrig.gif (1666 octets) Behavioral finance and market anomalies

BF research showq that markets are not fully efficient.
They have only some
degree of efficiency.

They show, mostly in the short term:

 

1) individual and collective investment mistakes as

    sources of insufficient returns or excessive risk-
    taking for most investors.
    This is "BF micro" or "Financial psychology"

2) general market inefficiencies, such as price or
    return anomalies between various assets and periods.

    This is "BF macro" or "Quantitative BF"

 

The cause is that people, and among them investors, are
not fully "rational".
 They are prone to irrationality /
bounded rationality, in the form of cognitive / emotional
biases.

They alter their decisions, make them shallow-based
(heuristic, framing) and/or "under influence" (anchoring,

groupthink).

 

Thus, BF tries:

1) to detect and understand those biases & anomalies,

2) if possible to use them in investment strategies


pi-arrig.gif (1666 octets) Main investors biases

What kind of psychological blunders

people do in the stock exchange (or other asset markets),

individually and as a crowd?

Kind of
biases

Individual biases

Collective biases

Cognitive

biases

 

 










Anchoring, attention bias,
attribution,
belief, cognitive
overcharge, cognitive

dissonance, fallacy, framing,
generalization, halo effect,
hindsight
bias, home bias,
(availability, representativeness)

heuristic, irrationality,
mental accounts,
reductionism, representation,
selective attention,
small
numbers, stereotype.
Cascade, common
belief / convention,
consensus, cultural
bias, groupthink,
meme, manipulation,
mimicry, paradigm,
percolation,
rational expectations
(positive feedback),
social learning,


 

  Emotional
 biases

 









Commitment, denial, greed,
fear, hope, (loss / risk,
uncertainty, regret)
aversion,
endowment effect, emotion,
feeling, house money,
magical thinking, optimistic
bias, over-confidence, pain,
pleasure, pride, status quo
bias, time horizon, wealth
effect.
Bandwagon,
conformity,
epidemics,
deification /

demonization,
fads, herding,
gullibility, mimicry,
home bias, peer
pressure, social
mood, trust.

 Autopilot
 biases

Addiction, habit, reflex

Social codes,
rules and rites


pi-arrig.gif (1666 octets) In practice: precautions for investors

1 - Activity

Avoiding inertia and indecision as
well as hyperactivity

2 - Reaction

Being sure to adjust to new situations
and information

3 - Anchoring /
      focusing

Trying not to be anchored on past
references / values

4 - Framing, 
      heuristic

Avoiding narrow interpretations and
over-simplifications

5 - Fallacy,
     attention

Revising erroneous knowledge and

beliefs

6 - Attitude -
     Aversion

Avoiding biased expectations of
pleasure / pain following decisions

7 - Emotion

Avoiding the primacy of emotions
over reason

8 - Mimicry,
     manipulation

Being wary of biased social influences
on decisions

9 - Magic

Being wary of illusive expectations

10 - Pride

Trying not to be blinded by one's ego

11 - Preferences

Trying to have clear and consistent
priorities

12 - Tilting

Trying to use - or to protect from -
market mispricing


pi-arrig.gif (1666 octets) Segmentation of market players

(typologies of trading strategies / styles / tools)

Types

Examples

of strategies

 

Noise trading vs. long term investing.
Value investing vs. growth investing....

of attitudes

 

Risk-averse / risk tolerant / risk 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 mket
evolutions) timing, momentum trading,

"Behavioral tools"
   users

BA, image coefficient, underreaction /
overreaction.


pi-arrig.gif (1666 octets) More elements on markets incidence
   of attitudes / behaviors 

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

Image coefficient levels

( measuring market perception,

representation, sentiment )

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

Price reactions

( to signals / information )

 

Underreaction, overreaction:
momentum, trends, cascades,
bubbles, crashes, rotations.

pi-separ.gif

 This page last update: 05/04/15
Previous page [stockprofiling]. 
 See also for details [ Behavioral finance]  

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