Main behavioral finance concepts
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
* There are anomalies of prices and returns.
* They are due to investors' mental biases.
=> BF studies those anomalies and biases.
The previous paradigms: EMH, RWH
The EMH have several versions (strong, semi-strong,
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
- 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)
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
They alter their decisions, make them shallow-based
(heuristic, framing) and/or "under influence" (anchoring,
Thus, BF tries:
1) to detect and understand those biases & anomalies,
2) if possible to use them in investment strategies
Main investors biases
What kind of psychological blunders
people do in the stock exchange (or other asset markets),
individually and as a crowd?
Anchoring, attention bias,
attribution, belief, cognitive
dissonance, fallacy, framing,
generalization, halo effect,
hindsight bias, home bias,
selective attention, small
belief / convention,
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
home bias, peer
Addiction, habit, reflex
rules and rites
In practice: precautions for investors
1 - Activity
Avoiding inertia and indecision as
well as hyperactivity
2 - Reaction
Being sure to adjust to new situations
3 - Anchoring /
Trying not to be anchored on past
references / values
4 - Framing,
Avoiding narrow interpretations and
5 - Fallacy,
Revising erroneous knowledge and
6 - Attitude -
Avoiding biased expectations of
pleasure / pain following decisions
7 - Emotion
Avoiding the primacy of emotions
8 - Mimicry,
Being wary of biased social influences
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
12 - Tilting
Trying to use - or to protect from -
Segmentation of market players
(typologies of trading strategies / styles / tools)
Noise trading vs. long term investing.
Value investing vs. growth investing....
Risk-averse / risk tolerant / risk seeker.
Active / passive. Aggressive /
FA (intrinsic data): comparing market
prices and economic value.
TA, QA (finding patterns in recent mket
evolutions) timing, momentum trading,
BA, image coefficient, underreaction /
More elements on markets incidence
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
( to signals / information )
momentum, trends, cascades,
bubbles, crashes, rotations.