Main behavioral finance concepts

Behavioral Finance (BF) is the application of psychology 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 has shown 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.

There are several versions (strong, semi-strong, weak) of the EMH.

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 each time new information arrive.

 

As those new information / events happen at random, prices and returns are supposed to:

evolve randomly (RWH / random walk hypothesis)

BF research has shown that markets are not completely efficient. They have only some

degree of efficiency. They show, mostly in the short term:

 

1) individual and collective investment mistakes, which are 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 totally "rational".  They are subject:

to irrationality / bounded rationality, in the form of cognitive / emotional biases that alter

their decisions.

Those decisions are 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

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, manipulation, meme, 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, overconfidence, 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	Institutional rules and rites

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

Types	Examples
Types of strategies	Noise trading vs. long term investing. Value investing vs. growth investing....
Types 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 market evolutions) timing, momentum trading,
"Behavioral tools" users	BA, image coefficient, underreaction / overreaction.

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

Image coefficient levels ( measuring market perception, representation, sentiment )	(as 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.

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