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1. Behavioral Finance - Introduction

One of the primary conventions of financial theory holds that participants in an economy are essentially
rational “wealth maximizers,” meaning that they will make decisions based on the information around
them and in a way that is as reasonable as possible. However, in actuality there are countless instances
in which emotion and psychology have undue influence upon our decisions, and the result is that
“rational” actors can display unpredictable or irrational behaviors.

The branch of economics which is concerned with this paradox is called behavioral finance. This
relatively new field seeks to combine behavioral and cognitive psychological theory with conventional
economic theory in order to propose explanations as to why people might make irrational financial
decisions.

Over the course of this tutorial, we will explain some of the anomalies (i.e., irregularities) which exist in
the real world but for which conventional financial theories have not accounted. Additionally, we will
aim to provide some insight into a few of the underlying biases and motivators which may cause certain
individuals to exhibit irrational behaviors. We’ll also explore how some actors in a financial ecosystem
have been able to capitalize on these irrational behaviors. Hopefully, in reading this tutorial, you will be
able to better protect yourself against acting against your best interests when it comes to financial
matters.

2. Behavioral Finance: Background

Before we examine the specific concepts central to behavioral finance, let’s take a broader look at this
branch of economic theory. In this section of the tutorial, we’ll explore how behavioral finance
compares to conventional finance, introduce you to three major contributors to the field and take a look
at behavioral finance from the perspective of a critic.

Why is behavioral finance necessary?

For clarification, when we use labels like “conventional” or “modern” to describe finance, we are
referring to the type of finance which is based on logical, rational theories. These include the capital
asset pricing model (CAPM) and the efficient market hypothesis (EMH), among many others. Theories
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like these take as an assumption that participants in an economy, for the most part, exhibit behaviors
that are rational and predictable. (For more insight, see The Capital Asset Pricing Model: An
Overview, What Is Market Efficiency? and Working Through The Efficient Market Hypothesis.)

There was a time when theoretical and empirical evidence seemed to suggest that CAPM, EMH and
other conventional financial theories were reasonably successful at predicting and explaining certain
types of economic events. Nonetheless, as time went on, academics in the financial and economic
realms detected anomalies and behaviors which occurred in the real world but which could not be
explained by any available theories. It became increasingly clear that conventional theories could
explain certain “idealized” events, but that the real world was in fact a great deal more messy and
disorganized, and that market participants frequently behave in ways which are difficult to predict
according to those models.

Homo Economicus

One of the fundamental assumptions in the world of conventional economics and finance asserts that
people are, for the most part, rational “wealth maximizers” who seek to increase their own financial
well-being through reasonable decision-making. According to conventional theories, people are able to
separate out emotions and various other extraneous factors so that they are not susceptible to their
influence.

In reality, though, this assumption does not reflect how people tend to behave. Indeed, nearly every
participant in an economy behaves irrationally in some way or other. To take a common
example: consider how many people purchase lottery tickets in the hopes of winning a big jackpot.
Taken logically, it does not make any sense to buy a lottery ticket if the odds of winning are
overwhelmingly against the ticket holder (the chances of winning the Powerball jackpot are roughly 1 in
146 million, or 0.0000006849%). However, in spite of this, millions of people spend countless dollars
taking part in the lottery.

Anomalies like this one provoked academics to turn to cognitive psychology in order to account for
irrational and illogical behaviors which are unexplained by modern financial theory. Behavioral science is
the field which was born out of these efforts; it seeks to explain our actions, whereas modern finance
seeks to explain the actions of the idealized “economic man” (Homo economicus).
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Important Contributors Behavioral finance has developed to the point it has today thanks to the
contributions of many individual theorists and researchers. Below, we’ll take a look at three of the most
significant contributors to major theoretical and empirical components of behavioral finance.

Daniel Kahneman and Amos Tversky Kahneman and Tversky are considered by many to be the fathers of
behavioral finance. These two cognitive psychologists began to collaborate with one another in the late
1960s, ultimately publishing about 200 works in the field. Most of the work of Kahneman and Tversky
focuses on how various psychological concepts relate to behavior in the financial realm. In 2002,
Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of
rationality in economics.

Kahneman and Tversky have specialized on cognitive biases and heuristics (i.e. ways of problem solving)
which cause individuals to engage in behavior which is both irrational and unanticipated. Some of their
most popular and important works include writings on prospect theory and loss aversion, which we’ll
explore later in this tutorial.

Richard Thaler If it can be said that Kahneman and Tversky were the founders of behavioral finance, it
follows that Richard Thaler brought the field out of its nascent state and into the mainstream.

Thaler developed his theories out of a growing awareness of the shortcomings of conventional financial
theories as they pertain to real-world behaviors. After he read a draft version of a work by Kahneman
and Tversky on prospect theory, Thaler came to the realization that psychological theory (rather than
conventional economics) could help to account for this irrationality.

Over time, Thaler collaborated with Kahneman and Tversky, combining economics and finance with
elements of psychology in order to develop concepts like mental accounting, the endowment effect and
other biases which have an impact on people’s behavior. (For more, see Who is Richard Thaler,
Economics Nobel Prize Winner?)

Critics of Behavioral Finance Behavioral finance has come to a place of prominence in the past decades,
with many academics adhering to its principles. However, this set of theories is not without critics, too.
For instance, some supporters of the efficient market hypothesis (EMH) are vocal critics of behavioral
finance.
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EMH is widely considered to be one of the foundations of modern finance. However, this hypothesis
fails to account for irrationality, because it assumes that the market price of a security reflects the
impact of any and all relevant information as it becomes available.

Eugene Fama is one of the most notable critics of behavioral finance. Fama is the founder of market
efficiency theory. He suggests that even though there do exist some anomalies for which modern
financial theory is not able to account, market efficiency theory remains the best model for examining
and predicting economies.

Fama even goes so far to note that many anomalies inherent in conventional theories could be seen as
shorter-term chance events which are eventually corrected as time goes on. In a 1998 paper entitled
“Market Efficiency, Long-Term Returns And Behavioral Finance,” Fama argued that many elements of
behavioral finance seem to be in contradiction with one another, and that all in all, behavioral finance
itself may be a collection of anomalies, the sum of which can actually be explained by market efficiency.

Critics Although behavioral finance has been gaining support in recent years, it is not without its critics.
Some supporters of the efficient market hypothesis, for example, are vocal critics of behavioral finance.

The efficient market hypothesis is considered one of the foundations of modern financial theory.
However, the hypothesis does not account for irrationality because it assumes that the market price of a
security reflects the impact of all relevant information as it is released.

The most notable critic of behavioral finance is Eugene Fama, the founder of market efficiency theory.
Professor Fama suggests that even though there are some anomalies that cannot be explained by
modern financial theory, market efficiency should not be totally abandoned in favor of behavioral
finance.

In fact, he notes that many of the anomalies found in conventional theories could be considered
shorter-term chance events that are eventually corrected over time. In his 1998 paper, entitled "Market
Efficiency, Long-Term Returns And Behavioral Finance", Fama argues that many of the findings in
behavioral finance appear to contradict each other, and that all in all, behavioral finance itself appears
to be a collection of anomalies that can be explained by market efficiency.
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3. Behavioral Finance: Anomalies

The fact that regularly occurring anomalies in conventional economic theories exist helped to prompt
the development of behavioral finance. These anomalies seem to directly violate modern financial and
economic theories that assume rational and logical behavior among participants. In this chapter, we’ll
explore some of the anomalies in these theories.

January Effect The January effect is so named because the average monthly return for small firms is
consistently higher in January than for any other month in the year. This phenomenon goes against the
efficient market hypothesis, which predicts that stocks should move at a "random walk." (For related
reading, see the Financial Concepts tutorial.)

One of the major departure points from which the January effect theory was established was a 1976
case study by Michael S. Rozeff and William R. Kinney. Rozeff and Kinney found that between 1904 and
1974, the average January returns for small firms was roughly 3.5%, while returns for all other months
was closer to 0.5%. They reported their findings in a paper called “Capital Market Seasonality: The Case
of Stock Returns.” Their findings suggest that the monthly performance of small stocks actually follows a
relatively consistent pattern (even if the returns themselves are not necessarily consistent between
January and other months). This consistency is contrary to the predictions made by conventional
financial theory. Therefore, Rozeff and Kinney believed that an unconventional factor was at play and
helped to contribute to the above-average January returns year after year.

There are a few possible explanations for a surge in January. One holds that this boost comes as a result
of investors who sell off dead-end stocks in December in order to achieve tax losses. This may lead to
returns bouncing back up in January, while investors have less of an incentive to sell. This may be an
important factor, but it’s not the only one: indeed, the phenomenon still exists in places where capital
gains taxes do not occur. (To read more, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

The Winner’s Curse Conventional financial theory assumes that investors are rational enough to
individually assess the true value of an asset and that they will then bid or pay accordingly. However,
anomalies in these theories suggest that this may not always be the case. The so-called “winner’s curse”
is one of them.
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The winner’s curse is a tendency for the winning bid in an auction setting to actually exceed the intrinsic
value of the item purchased. Obviously, this flies in the face of the assumption that investors will only
pay the true value for an asset.

Conventional theories assume that all participants taking part in the bidding process will have access to
all of the relevant information and that they will also all come to the same valuation for the item in
question. This means that any differences in the pricing of the item would suggest some other factor
which is not directly tied to the item itself is exerting an effect on the bidding.

Richard Thaler, behavioral finance pioneer, wrote a 1988 article on the winner’s curse in which he
proposed two primary factors which undermine the rationality of the bidding process: the number of
bidders and the aggressiveness of the bidding itself. As an example, the more bidders involved in the
process, the more aggressively each bidder must act in order to dissuade others from bidding. As a
corollary, increasing the aggressiveness with which you place bids will also increase the likelihood that a
winning bid will ultimately exceed the value of the asset in question.

A real-life example of the winner’s curse can be seen in the case of prospective homebuyers bidding for
a house. While it’s possible that all parties involved are rational, and that each knows the home’s true
value based on studies of recent sales of comparable homes in the area, valuation error can still occur. A
number of variables, including aggressive bidding and the presence of multiple bidders, can contribute
to this effect. The result is that the sale price of a home is regularly 25% or more above the true value of
the home. In this example, the curse manifests in two ways: not only has the winning bidder actually
overpaid considerably, but now that buyer may have a more difficult time securing financing. (For
related reading, see Shopping For A Mortgage.)

Equity Premium Puzzle One of the most confounding anomalies to conventional financial theory is
the equity premium puzzle. According to the capital asset pricing model (CAPM), investors holding
riskier financial assets should be compensated with higher rates of returns. (For more insight,
see Determining Risk And The Risk Pyramid.)

Long-term studies have revealed that, over a 70-year period, stock yields are, on average, in excess
of government bond returns by 6-7%. Stock real returns are 10%, while bond real returns are about 3%.
However, academics hold that an equity premium of 6% is extremely large and would imply that stocks
are considerably risky to hold in comparison with bonds. According to conventional economic models,
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this premium should actually be much lower. The disconnect between theoretical models and empirical
results is a major puzzle, and it confounds academics to this day.

Behavioral finance has proposed a solution to the equity premium puzzle. This answer suggests that the
tendency for people to have “myopic loss aversion,” a situation in which investors who are overly
preoccupied by the negative effects of losses in comparison to an equivalent amount of gains, tend to
take a short-term view on an investment. This results in those investors paying far too much attention to
the short-term volatility of their stock portfolios. Thus, a myopic (i.e., shortsighted) investor might react
negatively to downside changes, even though it’s common for average stocks to fluctuate by several
percentage points in either direction over a very short span of time. Because of this, behavioral finance
theorists believe that equities must yield a high-enough premium in order to compensate for the
investor’s outsized aversion to loss. In this way, the equity premium is seen as an incentive for market
participants to invest in stocks instead of somewhat safer government bonds.

The above anomalies are just a few of the real-world situations that behavioral finance has attempted to
explain. There are many other similar irrational or unpredictable phenomena which behavioral finance
has so far not attempted to address. None of this is to say, of course, that conventional financial theory
is not valuable; rather, the addition of behavioral financial theory can help to provide additional
clarification as to how investor behavior plays out in the real world.

4. Behavioral Finance: Key Concepts – Anchoring

In the subsequent chapters, we’ll take a look at 8 key concepts that behavioral finance theorists have
identified as contributing to irrational (and often detrimental) financial decision making. Chances are
that you have fallen prey to one or more of these biases at some point in the past.

Anchoring

Just as a house ought to be built on a good, solid foundation, so too should our ideas and opinions be
based on relevant, correct facts. Unfortunately, this is not always the case. The concept of “anchoring”
refers to the tendency we have to attach (or “anchor”) our thoughts to a reference point—even though
it may have no logical relevance to the decision at hand.
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Anchoring may sound counterintuitive. Nonetheless, it is prevalent in many situations and particularly in
those in which people are dealing with concepts that are new.

Diamond Anchor

One common example of “anchoring” is the conventional wisdom that a diamond engagement ring
should cost about two months’ worth of salary. This “standard” is in fact an example of highly illogical
anchoring. It’s true that spending two months of salary can serve as a benchmark when buying a
diamond ring, it is completely arbitrary and irrelevant as a reference point. In fact, it may have been
created by the jewelry industry in order to maximize profits.

Many individuals buying a ring cannot afford to spend two months of salary on this expense, on top of
other necessary expenses. As a result, many people go into debt in order to meet the “standard.” In
these cases, the diamond anchor can take on a new meaning as well, as the prospective ring buyer
struggles to stay afloat in a sea of rising debt.

In theory, the amount of money spent on an engagement ring should be dictated by what a person can
afford. In practice, though, many individuals anchor their decision on the irrational two-month standard,
revealing the power of anchoring.

Academic Evidence

It’s true that the two-month standard in the diamond ring example above does sound relatively
plausible. Nonetheless, academic studies have shown the anchoring effect to be so strong that it also
takes place in situations where the anchor is completely arbitrary and random.

A 1974 paper by Kahneman and Tversky entitled “Judgment Under Uncertainty: Heuristics And Biases”
shows the results of a study in which a wheel containing the numbers 1 through 100 was spun.
Subsequently, subjects were asked whether the percentage of U.N. membership accounted for by
African countries was higher or lower than the number on the wheel. Following that, the subjects were
asked to provide an actual estimate of this figure. Tversky and Kahneman discovered that the random
anchoring value of the number on which the wheel landed (which is completely unrelated to the
question) nonetheless had an anchoring effect on the answer that the subjects gave. For instance, if the
wheel landed on 10, the average estimate given by the subjects was 25%, while if the wheel landed on
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60, the average estimate was 45%. In both instances, the random number on the wheel inadvertently
drew subjects’ estimates closer to the number they were shown, in spite of the fact that it had
absolutely nothing to do with the question at hand.

Investment Anchoring

Anchoring is a phenomenon that occurs in the financial world, too. Investors sometimes base their
decisions on irrelevant figures and statistics. As an example, some investors invest in the stocks of
companies that have dropped considerably over a short span of time. These investors are likely
anchoring on a recent high point for the stock’s value, likely believing in some way that the drop in price
suggests that there is an opportunity to buy the stock at a discounted rate.

While it’s true that the overall market may cause some stocks to drop significantly in value, thereby
allowing investors to capitalize on short-term volatility, what is perhaps more likely is that a stock which
has dropped in value in this way has seen a change in its underlying fundamentals.

For instance, imagine that XYZ stock had strong revenue over the past year, contributing to a share price
rise from $25 to $80. In recent weeks, one of the company’s major customers, who contributed to 50%
of XYZ’s revenue, decided not to renew its purchasing agreement with the company. As a result, XYZ’s
share price drops from $80 to $40.

Investors who anchor to the previous high of $80 may erroneously believe that the stock is undervalued
at $40. In this case, though, XYZ is not being sold at a discount; in fact, the drop in share value reflects a
change in fundamentals (in this case, loss of revenue from a major customer). Investors who buy in at
$40 believing the stock is valued at $80 are thus victims to the anchoring phenomenon.

Avoiding Anchoring

The best way to avoid anchoring in your investment practices is to engage in rigorous critical thinking.
It’s best to be careful about the figures you utilize to evaluate a stock’s potential. The most successful
investors don’t base their decision on just one or two benchmarks. Rather, they evaluate each company
from a variety of perspectives in order to derive the truest picture of the investment landscape at hand.
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5. Behavioral Finance: Key Concepts - Mental Accounting

Mental accounting refers to the tendency people have to separate their money into different
accounts based on miscellaneous subjective criteria, including the source of the money and the
intended use for each account. The theory of mental accounting suggests that individuals are
likely to assign different functions to each asset group in this case, the result of which can be an
irrational and detrimental set of behaviors.

Many people use mental accounting. What these individuals may not realize, though, is that
this line of thinking is in fact highly illogical. For instance, some people keep a special “money
jar” or similar fund set aside for a vacation or a new home while at the same time carrying
substantial credit card debt. (For more insight, see Digging Out Of Personal Debt.)

In the example of the “money jar,” individuals are likely to treat the money in this special fund
differently from money that is being used to pay down debt, in spite of the fact that diverting
funds from the debt repayment process increases interest payments, thereby reducing the
person’s total net worth. Broken down further, it’s illogical (and, in fact, detrimental) to
maintain a savings jar that earns little or no interest while simultaneously holding cred-card
debt accruing double-digit figures annually. Individuals in this scenario would be best off using
the funds they have saved in the special account to pay off the expensive debt before it
accumulates any further.

Put in this way, the solution to this problem seems straightforward. Nonetheless, many people
do not behave in this way. The reason for this has to do with the type of personal value that
individuals place on particular assets. Many people feel, for example, that money saved for a
new house or a child’s college fund is simply “too important” to relinquish, even if doing so
would be the most logical and beneficial move.
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The Different Accounts Dilemma

Consider this example, which is designed to illustrate the importance of different accounts as
related to mental accounting: you have set for yourself a lunch budget for each week and you
are purchasing a $6 sandwich for lunch. As you go to buy the sandwich, one of the following
events takes place: 1) you find that you have a hole in your pocket and have lost $6; or 2) you
buy the sandwich, but as you go to take a bite, you trip and the sandwich falls on the floor. In
either case (assuming you still have enough money), does it make sense to buy another
sandwich? (To read more, see The Beauty Of Budgeting.)

Taken logically, the answer to both scenarios should in fact be the same, as it relates to your
total weekly lunch budget. In actuality, though, many people would behave differently
depending upon the scenario and as a result of the mental accounting bias. For that reason,
many people in the first scenario would go ahead and buy another sandwich based on the
feeling that the lost money was not part of the lunch budget, as it had not yet been spent or
allocated to that particular account.

Different Source, Different Purpose

A related aspect of mental accounting suggests that people tend to treat money differently
depending upon the source of that money. “Found” money, including tax refunds and work
bonuses as well as gifts, tends to be spent more freely than money earned through normal
paychecks. Again, logic would suggest that these monies should be treated in the same way,
but real world scenarios show otherwise.

Mental Accounting in Investing

People also tend to experience the mental accounting bias in investing as well. For instance,
many investors divide their investments between safe portfolios and speculative ones on the
premise that they can prevent the negative returns from speculative investments from
impacting the total portfolio. In this case, the difference in net wealth is zero, regardless of
whether the investor holds multiple portfolios or one larger portfolio. The only discrepancy in
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these two situations is the amount of time and effort the investor takes to separate out the
portfolios from one another.

Avoiding Mental Accounting

For investors looking to avoid the mental accounting bias, it’s crucial to remember that money
is fungible; regardless of its origins or intended use, all money is the same. Keeping this in mind
allows investors to cut down on frivolous spending of “found” money, to avoid wasting time
separating out accounts, and so on.

For many investors, the practice of maintaining money in a low- or no-interest account while
also carrying outstanding debt remains a common practice. In many cases, the interest on this
debt will erode any interest you could earn in a savings account. It’s important to have savings,
but in many cases it is more rational to forgo some of that savings in order to pay off debt.

6. Behavioral Finance - Key Concepts Confirmation and Hindsight Bias

There’s an old adage that states that “seeing is believing.” This may be the case, but there are
also some situations where this concept can be problematic. If what you perceive does not
accurately represent reality, for instance, we may see another example of a bias which has an
impact on an individual’s behavior within an economy. In this chapter we’ll explore how
confirmation and hindsight biases impact our perceptions and our subsequent decisions.

Confirmation Bias

Most of the time, whether we realize it or not, we go into many types of interactions with a
preconceived opinion of some type. During a first encounter, it can be difficult to shake these
opinions, as people tend to selectively filter and pay more attention to information which is in
support of their opinions as they simultaneously either ignore or rationalize the rest of the
information. This selective thinking impacts people in many different ways, and it is known as
a confirmation bias.
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Confirmation biases in investing suggest that an investor is more likely to look for information
that is in support of his or her idea about an investment than he or she is to find data which
contradicts it. Because we take in these types of information differently, we’re often subject to
faulty decision making as a result of one-sided information which skews our frame of reference.
Investors tend to have an incomplete picture of an investment situation because of
confirmation bias.

As an example, consider an investor who hears about a particularly hot stock from an unverified
source. That investor may conduct research on the stock in order to “prove” that its supposed
potential is real. In this case, the investor finds plenty of positive information which helps to
confirm his bias (this might include growing cash flow or a low debt/equity ratio). At the same
time, he is likely to gloss over or ignore major red flags, such as a loss of critical customers or
dwindling markets for the company.

Hindsight Bias

Hindsight bias is another common perception bias. This tends to take place in situations where
a person believes (after the fact) that the onset of a previous event was both predictable and
obvious. In many cases, however, the event was by no means obvious or predictable.

In hindsight, many events seem very obvious. From a psychological standpoint, we may
experience hindsight bias as a result of a human need to find order in the world; we create
explanations which allow us to believe that events from the past were predictable. Hindsight
bias and the ways of thinking wrapped up in it are not necessarily bad, but they can sometimes
lead investors to find erroneous “links” between the cause and the effect of an event, thereby
oversimplifying the situation and making poor decisions in the future.

Take an example of individuals who believe that the technology bubble of the early 2000s was
obvious. The same kinds of hindsight bias can be found for essentially any historical bubble,
including the tulip bubble from the 1630s. In each case, this represents a clear example of a
hindsight bias: if the information about a bubble had truly been obvious, it’s likely that
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investors would not have bought in, and the bubble would not have burst. (To learn more,
read The Greatest Market Crashes.)

Hindsight bias can lead investors down the dangerous path toward overconfidence. If an
investor grows overconfident, he or she maintains an unfounded belief that he or she possesses
superior stock-picking or investing abilities. Inevitably, this ends up leading to damaging
financial decisions if allowed to unfold over a long period of time.

Avoiding Confirmation and Hindsight Bias

Confirmation and hindsight biases are tendencies that we have to focus on information that
confirms some pre-existing thought, or to generate an explanation for a past event which
makes it seem inevitable or obvious. There are numerous problems with these biases, but one
of the most important to keep in mind is that the fact of being aware that we maintain
confirmation and hindsight biases is not sufficient to prevent us from having them. For that
reason, investors are encouraged to find someone to act as a “dissenting voice of reason.” If
forced to defend your investment decisions and viewpoints from a contrary opinion, you’re
more likely to see holes in your arguments.

7. Behavioral Finance: Key Concepts - Gambler's Fallacy

If you do not properly understand probability, you are more likely to make incorrect
assumptions and predictions about certain types of events. The next bias that we’ll explore is
called the gambler’s fallacy.

The gambler’s fallacy refers to the tendency of individuals to erroneously believe that the onset
of a particular random event is more or less likely to happen following another event or a series
of events. Logically, this line of thinking is incorrect; past events do not affect the probability
that certain events will occur at a later time.

As an example, we might consider flipping a coin. If the coin has been flipped 20 times in a row
and has landed with the “heads” side up each time, someone experiencing the gambler’s fallacy
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might predict that the next flip is more likely to land with the “tails” side up. After all, if it has
landed with “heads” up so many times, it must be about time for the other outcome to occur,
correct?

In fact, this is a completely inaccurate approach. The likelihood of a fair coin turning up heads
or tails is always 50%. Because each coin flip is an independent event, all previous flips (no
matter how unusual their outcomes) have no bearing on future flips.

Slot machines are another example of a gambler’s fallacy approach. The common picture of the
“slot jockey” has someone sit in front of a slot machine for hours at a time. Some of these
people believe that each losing pull is somehow bringing them closer to winning a big jackpot.
However, what these gamblers don’t realize is that slot machines are designed to have the
same odds of winning a jackpot for every single pull. For this reason, it makes no difference if
you play with a machine that just hit the jackpot or on one that has not produced a win in a
long time.

Gambler’s Fallacy in Investing

In many situations, investors can fall prey to the gambler’s fallacy as well. As an example, some
investors hold that they should sell out of a position if it has gone up over several trading
sessions. The thinking behind this is that the position is unlikely to continue to increase. On the
other hand, some investors might hold on to a stock that has fallen for several consecutive
session because it seems like it’s “time” for the stock to pick back up. There are other factors at
play, and the situation is more complicated than the flip of a coin, but this line of thinking is a
reflection of the gambler’s fallacy nonetheless. (For more, see Five Mental Mistakes That Affect
Stock Analysts).

Avoiding the Gambler’s Fallacy

To avoid the gambler’s fallacy, investors should remember that the odds of any specific
outcome happening on the next chance of an independent event is the same, regardless of
what preceded it. This applies in the stock market as well as in the illustrative examples above:
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buying a stock because you believe the prolonged trend is likely to reverse at some point soon
is an example of irrational behavior. Rather, investors should look to
sound fundamental and/or technical analysis in order to predict what will happen with a trend.

8. Behavioral Finance: Key Concepts - Herd Behavior

One of the most notorious financial events in the past several years was the financial crisis of
2008, which involved a real estate bubble which burst. This was not the first time that events
like this have taken place in the markets, and it’s unlikely to be the last. The question, then, is
how could something as catastrophic as this happen over and over again?

Part of the answer to this question is attributable to a hardwired human tendency: herd
behavior. Herd behavior represents the tendency for an individual to mimic the actions of a
larger group, whether those actions are rational or irrational. In many cases, herd behavior is a
set of decisions and actions that an individual would not necessarily make on his or her own.

Why does herd behavior happen, particularly if it results in harmful or irrational actions? One
reason is that there is a strong social pressure afforded to conformity. This pressure is likely
familiar to many of us, as most people are very sociable and have a natural desire to be
accepted by a group, rather than be branded as an outcast. Following the group and its
behavior seems to be a natural way of becoming a member of that group.

Another reason for herd behavior is the rationale that the more people buy into a decision, the
less likely it is that the decision is incorrect. Even if an individual believes that the action is
irrational or inadvisable, he or she is more likely to be swayed if others have already engaged in
that behavior. When an individual has little experience or expertise in an area, this behavior can
become even more prevalent.

The Dotcom Herd

A prominent example of herd mentality in the financial and investing worlds was the dotcom
bubble in the late 1990s. Venture capitalists and private investors made frantic moves to invest
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huge amounts of money into internet companies, in spite of the fact that many of
those dotcoms didn’t have business models that were financially sound. The reason many
investors moved their money in this way likely has something to do with the reassurance they
received from seeing so many other investors do the same thing. Critics of the cryptocurrency
boom of recent years suggest that a similar phenomenon may be taking place in that space.
(For more, see How to Find Your Next Cryptocurrency Investment)

We’re all subject to herd mentality, even financial professionals. The primary goal of a money
manager is to adhere to an investment strategy in order to maximize a client’s wealth. These
clients may exert pressure upon money managers to “buy in” to new investment fads as they
come about. A wealthy client may hear about an investment gimmick which is gaining
popularity and then inquire with a money manager about whether that manager employs a
similar strategy. Money managers thus feel pressure to follow general trends.

The Costs of Being Led Astray

In many cases, herd behavior is not a sound or profitable investment strategy. Investors who
are easily swayed by the herd tend to buy and sell assets frequently as they chase the latest
investment trends. These investors tend to free up as much investment capital to put all of
their money into the latest sector, company, or strategy, switching when the next fad comes
along.

A downside to this type of behavior is that the frequent buying and selling tends to incur a
substantial amount of transaction costs, eating away at potential profits. That’s to say nothing
of the rationality of focusing one’s investments so densely in one area at a time, as well. It is
extraordinarily difficult to time trades such that an investor enters a position when the trend is
starting. Most herd investors only find out about the latest trend after other investors have
taken advantage of it, and the strategy’s potential for generating wealth has likely come and
gone.
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Avoiding the Herd Mentality

All investors feel some temptation to follow the latest investment trends. However, investors
who steer clear of the herd and maintain their own independent strategies and investment
principles are likely to avoid the heartbreak that can come with being involved in an investment
trend gone wrong. The best advice is to always do your homework before buying in to any
trend. (For related reading, see How Investors Often Cause The Market's Problems.)

9. Behavioral Finance: Key Concepts – Overconfidence

A landmark study entitled “Behaving Badly” is a useful introduction to our next source of bias
and irrational behavior: overconfidence. In 2006, researcher James Montier found that a
whopping 74% of 300 professional fund managers he surveyed believed that they had delivered
above-average job performance. The majority of the remaining 26% of those surveyed believed
that they were average in their performance. Nearly 100% of those surveyed felt that their
performance was average or better. In actuality, of course, only 50% of a sample can be above
average. This discrepancy suggests that many of these fund managers displayed an irrationally
high level of overconfidence. (For related reading, see 8 Psychological Traps Investors Should
Avoid)

Overconfidence reflects the tendency to overestimate or exaggerate one’s ability to

successfully perform a given task, and it is a trait that is common among people in all
professions and areas. To illustrate this, consider the number of times that you’ve participated
in a competition or a contest with the attitude that you have what it takes to win, regardless of
the number of competitors in the field or the fact that most competitions have only one
winner.

While confidence can be a beneficial thing, overconfidence is often detrimental. The distinction
between the two is subtle and often difficult to assess; confidence suggests a realistic trust in
one’s abilities, while overconfidence implies an overly optimistic assessment of one’s
knowledge or level of control over a particular situation.
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Overconfidence in Investing

Overconfidence can be harmful to an investor’s ability to pick stocks over the long term. A 1998
study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,”
written by researcher Terrence Odean, illustrates this. The study found that overconfident
investors typically conducted more trades as compared with their less-confident counterparts.

Perhaps unsurprisingly, overconfident investors believed that they were better than others at
picking the best stocks and times to enter or exit a position. Odean also found that traders
conducting the most trades tended, on average, to actually receive yields significantly lower
than the market. (To learn more, check out Understanding Investor Behavior.)

Avoiding Overconfidence

To avoid overconfidence, it can be useful to remember that even professional fund managers
and traders with access to the best reports and computational models still struggle to achieve
market-beating returns. Those fund managers who maintain realistic estimations of themselves
and their abilities know that every investment day offers a new set of challenges and that no
investment technique is perfect. Indeed, most overconfident investors are only a trade away
from a very humbling wake-up call. (For more, see 4 Behavioral Biases and How to Avoid Them)

10. Behavioral Finance: Key Concepts - Overreaction and

Availability Bias

The concept of market efficiency assumes that new information about a security will be
reflected more or less instantaneously in the price of that security in the market. Good news
about a company should increase the business’ share price a proportional amount, and that
price should then remain steady until new information about the company becomes available.

In reality, though, this idealized expectation rarely comes to pass in such a clean, unimpeded
fashion. Often, participants in the stock market actually overreact to new information, thereby
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creating an impact on the price of a security which is larger than it should be relative to the
scope of the information. Additionally, the price surge which customarily accompanies good
news is not a permanent trend; rather, it tends to erode over time, even if no new information
has been introduced.

Winners and Losers

Behavioral finance theorists Werner De Bondt and Richard Thaler released a 1985 study in the
Journal of Finance called “Does the Market Overreact?” In their paper, the two researchers
explored the returns on the New York Stock Exchange over a three-year period. From the stocks
they analyzed, De Bondt and Thaler separated out the 35 top performing stocks into a “winners
portfolio” and the 35 lowest performing stocks into a “losers portfolio.” The study tracked each
portfolio’s performance as compared with a representative market index over three years.

As it turns out, the losers portfolio actually beat the market index consistently. On the other
hand, the winners portfolio consistently underperformed the market. Over the three-year
period, the cumulative difference between the two portfolios was nearly 25%; put differently,
the original “winners” tended to become “losers,” and vice versa.

Why did this happen? In the case of both winning and losing stocks, investors tended to
overreact. For losing stocks, investors overreacted to negative news, thereby driving the stocks’
share prices down artificially and disproportionately. Over time, though, it became clear that
this pessimism was outsized, and the losing stocks actually began to rebound as investors
realized that the stocks were underpriced. The same is true in reverse for the winners portfolio,
as investors eventually understood that their initial enthusiasm was overblown.

Part of the reason for this overreaction has to do with the availability bias. According to this
bias, people tend to weigh their decisions more heavily toward recent information. New
opinions thus become biased toward the latest news. (For more, see How Cognitive Bias Affects
Your Business)
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Availability bias can creep into our lives in subtle ways as well as significant ones. For example,
imagine that you see a car accident along a stretch of road that you drive on regularly during
your commute to work. It’s likely that you’ll be more cautious on that stretch of road, at least
for a few days after the accident. You may be inclined to behave in this way even if the level of
danger on the road has not changed at all; seeing the accident caused you to overreact.
However, over time, it’s likely that you’ll regress to your previous driving habits.

Avoiding Availability Bias

We are all subject to availability bias and overreaction in various ways, and it can be difficult to
keep those things in check. One of the ways to do so, however, is to work on retaining a sense
of perspective over the long term. It can be easy to get caught up in the latest news, but short-
term investment approaches rarely yield the best results. You are likely better served by
thoroughly researching your investments so that you can accurately assess the impact of the
daily news cycle without being likely to overreact in the short term.

11. Behavioral Finance: Key Concepts - Prospect Theory

Common sense might suggest that individuals combine the net effect of the gains and the
losses associated with any choice in order to make an educated evaluation of whether that
choice is desirable. An academic way of viewing this is through the concept of “utility,” often
used to describe enjoyment or desirability; it seems logical that we should prefer those
decisions which we believe will maximize utility.

On the contrary, though, research has shown that individuals don’t necessarily process
information in such a rational way. In 1979, behavioral finance founders Kahneman and Tversky
presented a concept called prospect theory. Prospect theory holds that people tend to value
gains and losses differently from one another, and, as a result, will base decisions on perceived
gains rather than on perceived losses. For that reason, a person faced with two equal choices
that are presented differently (one in terms of possible gains and one in terms of possible
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losses) is likely to choose the one suggesting gains, even if the two choices yield the same end
result.

Prospect theory suggests that losses hit us harder. There is a greater emotional impact
associated with a loss than with an equivalent gain. As an example, consider how you may react
to the following two scenarios: 1) you find $50 lying on the ground, and 2) you lose $50 and
then subsequently find $100 lying on the ground. If your reaction to the former scenario is
more positive than to the latter, you are experiencing the bias associated with prospect theory.

Evidence for Irrational Behavior

Kahneman and Tversky engaged in a series of studies in their work toward developing prospect
theory. Subjects were asked questions involving making judgments between two monetary
decisions that involved potential gains and losses. Here is an example of two questions used in
the study:

1. You have $1,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of gaining $1,000, and a $50 chance of gaining $0.

Choice B: You have a 100% chance of gaining $500.

2. You have $2,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.

Choice B: You have a 100% chance of losing $500.

If these questions were to be answered logically, a subject might pick either “A” or “B” in both
situations. People who are inclined to choose “B” would be more risk adverse than those who
would choose “A”. However, the results of the study showed that a significant majority of
people chose “B” for question 1 and “A” for question 2.
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The implication of this result is that individuals are willing to settle for a reasonable level of
gains (even if they also have a reasonable chance of earning more than those gains), but they
are more likely to engage in risk-seeking behaviors in situations in which they can limit their
losses. Put differently, losses tend to be weighted more heavily than an equivalent amount of
gains.

This line of thinking resulted in the asymmetric value function:

This chart represents the difference in utility (i.e. the amount of pain or joy) that is achieved as
a result of a certain amount of gain or loss. This value function is not necessarily accurate for
every single person; rather, it represents a general trend. One critical takeaway from this
function is that a loss tends to create a greater feeling of pain as compared to the joy created
by an equivalent gain. In the case of the chart, the absolute joy felt in finding $50 is significantly
less than the absolute pain caused by losing $50.

As a result of this tendency, during a series of multiple gain/loss events, each event is valued
individually and then combined in order to create a cumulative feeling. Thus, if you were to find
$50 and then lose $50, you’d probably end up feeling more frustrated than you would if you
hadn’t found or lost anything. This is because the amount of joy gained from finding the money
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is outweighed by the amount of pain experienced by losing it, so the net effect is a “loss” of
utility.

Financial Relevance

Many illogical financial behaviors can be explained by prospect theory. For example, consider
people who refuse to work overtime because they don’t want to pay more taxes. These people
would benefit financially from the additional after-tax income, but prospect theory suggests
that the benefit they would achieve from earning extra money for additional work does not
outweigh the sense of loss they feel when they pay additional taxes.

The disposition effect is the tendency that investors have to hold on to losing stocks for too
long and to sell winning stocks too soon. Prospect theory is useful in explaining this
phenomenon as well. The logical course of action would be to do the opposite: to hold on to
winning stocks in order to further gains, while selling losing stocks in order to prevent
additional losses.

The example of investors who sell winning stocks prematurely can be explained by Kahneman
and Tversky’s study, in which individuals settled for a lower guaranteed gain of $500 as
compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in
the study and investors who hold winning stocks in the real world are overeager to cash in on
the gains that have already been guaranteed. They are unwilling to take a risk to earn larger
gains. This is an example of typical risk-averse behavior. (To read more, check out A Look At Exit
Strategies and The Importance Of A Profit/Loss Plan.)

On the other hand, though, investors also tend to hold on to losing stocks for too long.
Investors tend to be willing to assume a higher level of risk on the chance that they could avoid
the negative utility of a potential loss (just like the participants in the study). In reality, though,
many losing stocks never recover, and those investors end up incurring greater and greater
losses as a result. (To learn more, read The Art Of Selling A Losing Position.)
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Avoiding the Disposition Effect

It is possible to reduce the disposition effect, thanks to a concept called hedonic framing. As an
example, for situations in which you have a chance of thinking of something as one large gain or
as a number of smaller gains (i.e. finding a $100 bill versus finding a $50 bill and then later
finding another $50 bill), it’s best to think of the latter option. This will help to maximize the
positive utility you experience.

On the other hand, for situations where you could either think of a situation as one large loss or
as a number of smaller losses (i.e. losing $100 or losing $50 two times), it’s better to think of
the situation as one large loss. This creates less negative utility, because there is a difference in
the amount of pain associated with combining the losses and with the amount associated with
taking multiple smaller losses.

In a situation you could interpret as either one large gain with a smaller loss or a single smaller
gain (i.e. $100 and -$50, or +$50), it’s likely that you’ll achieve more positive utility from the
single smaller gain.Lastly, in situations that could be thought of as a large loss with a smaller
gain or as a smaller loss (i.e., -$100 and +55, versus -$45), it may be best to frame the situation
as separate losses and gains.

Try these methods of framing your thoughts, and you may find that they help you to experience
these situations more positively. Training yourself to reframe situations in this way can also
help to avoid the disposition effect.

12. Behavioral Finance: Conclusion

Whether it’s unnecessary anchoring, availability bias, or simply following the herd, chances are
that we’ve all been guilty of at least some of the biases and irrational behaviors that we’ve
explored in the previous chapters of this tutorial. However, armed with the awareness of some
of the biases we regularly take into our financial practices, you can now apply that knowledge
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to your own investing in order to take corrective action where necessary. Hopefully, your future
financial decisions will be somewhat more rational and a lot more lucrative as a result.

In summary, here is what we covered over the preceding chapters:

 Conventional finance utilizes theories that assume people act logically and rationally.
However, the presence of anomalies eventually revealed that individuals don’t always
behave in this way, and conventional finance models have a difficult time explaining
these behaviors.
 Behavioral finance was the result of this discovery. It was pioneered by psychologists
like Drs. Daniel Kahneman and Amos Tversky as well as economists like Richard Thaler.
 Anchoring is a bias described by behavioral finance. It reflects our tendency to attach (or
“anchor”) our thoughts around a reference point, whether or not that reference has any
logical bearing on the decision at hand.
 Mental accounting captures our tendency to divide money into different accounts based
on criteria such as the source of the money and the intended spending. The importance
placed on each account also varies.
 Confirmation and hindsight biases prove that seeing is not necessarily believing.
A confirmation bias shows that people tend to be more attentive toward new
information which confirms a preconceived opinion or belief. Hindsight bias, on the
other hand, explains why we might believe that, after the fact, the occurrence of an
event was obvious.
 When we incorrectly believe that the occurrence of an independent event somehow
makes another unrelated independent event less likely to happen, we are falling prey to
the gambler’s fallacy.
 As individuals, we tend toward herd behavior: this reflects our propensity for following
the decisions of a large group, whether or not those decisions are rational.
 Many investors tend to be overconfident, believing that they are better able to perform
a certain action or task than they actually are.
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 Overreaction refers to our tendency to react to a piece of new information with a

disproportionately strong response.
 Drs. Kahneman and Tversky developed prospect theory to reflect the way that people
interpret gains and losses differently. On average, individuals tend to be more sensitive
to a loss than to a gain of equal value.