Behavioural Finance

Behavioural finance is the study of the effects of psychology on investors and financial
markets. It focuses on explaining why investors often appear to lack self-control, act against
their own best interest, and make decisions based on personal biases instead of facts.
Behavioural finance is the study of psychological influences on investors and financial
markets. At its core, behavioural finance is about identifying and explaining inefficiency and
mispricing in financial markets. It uses experiments and research to demonstrate that humans
and financial markets are not always rational, and the decisions they make are often flawed.
Behavioural finance originated from the work of psychologists Daniel Kahneman and Amos
Tversky and economists Richard Thaler and Robert J. Shiller in the 1970s-1980s. They
applied the persuasive, deep-seeded, subconscious biases and heuristics to the way that
people make financial decisions. At about the same time, financial researchers began to
propose the efficient market hypothesis (EMH), a popular theory that the stock market moves
in rational, predictable ways, and doesn't always hold up under scrutiny. In reality, the
markets are full of inefficiencies due to investors’ flawed thinking about prices and risk. In
the past decade, behavioural finance has been embraced in the academic and financial
communities as a subfield of behavioural economics influenced by economic psychology. By
showing how, when and why behaviour deviates from rational expectations, behavioural
finance provides a blueprint to everyone to make better, more rational decisions when it
comes to their finances. Understanding economic behaviour and economic psychology is a
field of study called behavioural economics. It uses psychology and economics to explore
why people sometimes make emotional rather than logical decisions and why their behaviour
doesn’t follow the predictions of accepted economic models. It looks for answers to questions
such as why even experienced investors buy too late and sell too soon, or why someone
doesn’t use their savings account to help with paying off massive credit card debt. It even
studies anomalies such as the small but measurable advantage companies have in the market
if the stock ticker abbreviations come first in the alphabet, or the effect of the weather on the
market values. Behavioural economics has also identified that systematic errors and biases
recur predictably in certain circumstances, offering a framework for understanding when and
how people make mistakes. There are two types of human behaviour that factor heavily in
behavioural economics: heuristics and biases. According to behavioural economist Herbert
Simon, most people use heuristics when confronted with a complex decision. Heuristics are
mental shortcuts we use to decide something quickly or not at all. Investors and financial
professionals often use heuristics when analysing financial decisions. Heuristics are often
based on assumptions or rules of thumb that often but not always, hold true. An example of a
common heuristic is to assume that the past investment performance indicates future returns.
Although that seems to make sense on the surface, it doesn’t take into account changes in the
economy or how fully valued a stock has become. An investor might assume that because an
emerging markets equity mutual fund has posted positive returns for the past five years, a
sensible decision would be to maintain or increase the position in the fund. However, it’s
possible that the mutual fund has undergone a turnover in management, or oil prices have
risen which affects shipping costs to these markets, for example. A mental shortcut in
investment analysis can have an adverse effect on a portfolio. Another example is seeing a
“sale price” and assuming that it’s a good deal because it’s below the normal price.
Sometimes it’s a good deal, but other times it isn’t. This heuristic is based on the tendency to
believe a reference point is real because of how it’s reported. In this case, it’s the price a tag
says is the normal price. Making a price decision based on an inaccurate reference number
can result in negative consequences. Fortunately, when people become aware of errors caused
by heuristics, they can adjust their decision-making processes. Not only that, but they can
also learn which heuristics are reliable. In finance, some heuristics such as the 10% savings
rule, the 70% replacement ratio in the retirement rule, and the “cost-per-use” strategy to make
purchasing decisions are effective. Trading psychology refers to the mental state and
emotions of a trader that determine the success or failure of a trade. Assumption heuristics,
such as making a decision based on one positive result, anchoring bias, loss aversion and
confirmation bias can yield less than desirable investment or financial outcomes. Human
economic and financial heuristics and biases affect economic markets, the odd mix of
collective and independent decisions of millions of people, acting for themselves and on
behalf of funds or companies. As a result, many markets are not successful for many years.
Understanding what causes the anomalies in valuations of individual securities and the stock
market can result in better market performance. Suboptimal financial decision making is the
result of cognitive errors, many of which are made because of heuristics and anchoring, self-
attribution and framing biases. Exploring neuroscience discoveries and the implications for
financial decision making under uncertainty can result in sounder strategies for client
debiasing and financial management. Behavioural finance is now being implemented in
financial advisor business models and client engagement practices. For financial analysts,
asset managers and the investment process itself, behavioural finance is also growing in
importance as the basis of an investment methodology.
Behavioural Heuristics and Biases

Heuristics

Heuristics is the process of simplifying a problem when you don’t have information to make
a “perfect” decision. In these instances, you are likely to use a shortcut or rule-of thumb to
make a decision that feels right. Heuristics simplify the decision-making process, which
means they simplify the financial decision-making process as well. Without them, you’d have
to spend much more time making decisions. However, relying on heuristics without carefully
analysing investment options can lead to irrational or incorrect decisions. Heuristics are
mental shortcuts that can facilitate problem solving and probability judgements. These
strategies are generalisations or rules-of-thumb that reduce cognitive load. They can be
effective for making immediate judgements, however, they often result in incorrect or
inaccurate conclusions. The thing about heuristics is that they aren’t always wrong. As
generalisations, there are many situations where they can yield accurate predictions or result
in good decision making. However, even if the outcome is favourable, it was not achieved
through logical means. When we use heuristics, we risk ignoring important information and
overvaluing what is less relevant. There is no guarantee that using heuristics will work out,
and even if it does, we’ll be making the decision for the wrong reason. Instead of basing it on
reason, our behaviour is resulting from a mental shortcut with no real rationale to support it.
The first three heuristics – availability, representativeness as well as anchoring and
adjustment – were identified by Tversky and Kahneman in their 1974 paper, “Judgment
under Uncertainty: Heuristics and Biases”. In addition to presenting these heuristics and their
relevant experiments, they listed the respective biases each can lead to. For instance, upon
defining the availability heuristic, they demonstrated how it may lead to illusory correlation,
which is the erroneous belief that two events frequently co-occur. This may result in drawing
correlations between variables when in reality there are none. Referring to our tendency to
overestimate our accuracy making probability judgments, Kahneman and Tversky also
discussed how the illusion of validity is facilitated by the representativeness heuristic. The
more representative an object or event is, the more confident we feel in predicting certain
outcomes. The illusion of validity, as it works with the representativeness heuristic, can be
demonstrated by our assumptions of others based on past experiences. Representativeness is
not only the factor in determining the probability of an outcome or event, meaning we
shouldn’t be as confident in our predictive abilities. In their paper, “Judgment under
Uncertainty: Heuristics and Biases”, Kahneman and Tversky identified three different
heuristics: availability, representativeness, as well as anchoring and judgment. Each type of
heuristic is used for the purpose of reducing the mental effort needed to make a decision, but
they occur in different contexts.

Availability Heuristic

The availability heuristic often happens when we are attempting to judge the frequency with
which an event occurs. Say, for example, one wants to judge whether more tornadoes occur
in Kansas or Nebraska. Most of us can easily call to mind an example of a tornado in Kansas:
the tornado that whisked Dorothy Gale off to Oz in Frank L. Baum’s The Wizard of Oz.
Although it’s fictional, this example comes to us easily. On the other hand, most people have
trouble calling to mind, an example of a tornado in Nebraska. This leads us to believe that
tornadoes are more common in Kansas than in Nebraska. However, the states actually report
similar levels of tornadoes. The availability heuristic, as defined by Tversky and Kahneman,
is the mental shortcut used for making frequency or probability judgments based on “the ease
with which instances or occurrences can be brought to mind”. This was touched upon in the
example, judging the frequency with which tornadoes occur in Kansas relative to Nebraska.
The availability heuristic occurs because certain memories come to mind more easily than
others. In Kahneman and Tversky’s example participants were asked if more words in the
English language start with the letter K or have K as the third letter. Interestingly, most
participants responded with the former when in actuality, it is the latter that is true. The idea
being that it is much more difficult to think of words that have K as the third letter than it is
to think of words that start with K. In this case, words that begin with K are more readily
available to us than the words with K as the third letter. The availability heuristic describes
our tendency to use information that comes to mind quickly and easily when making
decisions about the future. The availability heuristic can lead to bad decision making because
memories that are easily recalled are often insufficient for figuring out how likely these
things are to happen again. Ultimately, our overestimation leaves us with low quality
information to form the basis of our decisions. Meanwhile, less memorable events that
contain better quality evidence to form our predictions remain untouched. Acknowledging
availability heuristic force us to re-examine what we once held true about decision making.
Many prevailing theories in behavioural economics frame humans to be rational choosers,
proficient at evaluating information. In reality, each one of us, analyses information in a way
that prioritizes memorability and proximity over accuracy. This startling misjudgement in
mental capacity means that academics and professionals alike will have to revisit their basic
assumptions about how people think and act to enhance the quality of behavioural
predictions. A heuristic is a rule-of-thumb or a mental shortcut that guides us. As with any
heuristic, the availability heuristic helps us make choices easier and faster by drawing
information from our memory. However, the trade-off for this snap judgment is losing our
ability to accurately gauge the probability of certain events, as our memories may not be
realistic models for forecasting future outcomes. Unfortunately, we fall victim to this
miscalculation every day.

Representativeness Heuristic

Individuals tend to classify events into categories, which, as illustrated by Kahneman and
Tversky, can result in our use of the representativeness heuristic. When we use this heuristic,
we categorise events or objects based on how they relate to instances we are already familiar
with. Essentially, we have built our own categories, which we use to make predictions about
novel situations or people. For example, if someone we meet in one of our university lectures
looks and acts like what we believe to be a stereotypical medical student, we may judge the
probability that they are studying medicine as highly likely, even without any hard evidence
to support that assumption. The representativeness heuristic is associated with prototype
theory. This prominent theory in cognitive science, the prototype theory explains object and
identity recognition. It suggests that we categorise different objects and identities in our
memory. For example, we may have a category for chairs, a category for books, a category
for fish, and so on. Prototype theory posits that we develop prototypical examples for these
categories by averaging every example of a given category we encounter. As such, our
prototype of a chair should be the most average example of a chair possible, based on our
experience with that object. This process aids in object identification because we compare
every object we encounter against the prototypes stored in our memory. The more the object
resembles the prototype, the more confident we are that it belongs in that category.

Anchoring and Adjustment Heuristic

Another heuristic put forth by Kahneman and Tversky in their initial paper is the anchoring
and the adjustment heuristic. This heuristic explains how, when estimating a certain value, we
tend to give an initial value, then adjust it by increasing or decreasing our estimation.
However, we often get stuck on that initial value – which is referred to as anchoring – this
results in us making insufficient adjustments. Thus, the adjusted value is biased in favour of
the initial value we have anchored to. In an example of the anchoring and adjustment
heuristic, Kahneman and Tversky gave participants questions such as “estimate the number
of African countries in the United Nations (UN)”. A wheel labelled with numbers from 0-100
was spun, and participants were asked to say whether or not the number the wheel landed on
was higher or lower than their answer to the question. Then, participants were asked to
estimate the number of African countries in the UN, independent from the number they had
spun. Regardless, Kahneman and Tversky found that participants tended to anchor onto the
random number obtained by spinning the wheel. The results showed that when the number
obtained by spinning the wheel was 10, the median estimate given by participants was 25,
while, when the number obtained from the wheel was 65, participants’ median estimate was
45.8. A 2006 study by Epley and Gilovich “The Anchoring and Adjustment Heuristic: Why
the Adjustments are Insufficient” investigated the causes of this heuristic. They illustrated
that anchoring often occurs because the new information we anchor to is more accessible than
the other information. Furthermore, they provided empirical evidence to demonstrate that our
adjustments tend to be insufficient because they require significant mental effort, which we
are not always motivated to dedicate to the task. They also found that providing incentives for
accuracy led participants to make more sufficient adjustments. So, this particular heuristic
generally occurs when there is no real incentive to provide an accurate response.

Though different in their explanations, these three heuristics allow us to respond

automatically without much effortful thought. They provide an immediate response and do
not use much of our mental energy. As illustrated by Kahneman and Tversky, using heuristics
can cause us to engage in various cognitive biases and commit certain fallacies. As a result,
we may make poor decisions, as well as inaccurate judgements and predictions. Awareness of
heuristics can aid us to avoid them, which will ultimately lead us to engage in more adaptive
behaviours.

Cognitive Biases

Overconfidence

Most people tend to overestimate their abilities in many areas. For instance, 65% of
Americans think their intelligence is above average and 73% think they’re better than average
drivers. When you overestimate how much you know about the market or a specific stock,
you’ll be tempted to make risky decisions like trying to time the market, which is trying to
predict the best time to buy or sell stocks, or overinvesting in high-risk stocks, which are
more likely to lose money. Overconfidence bias is the tendency for a person to overestimate
their abilities. A wealth of easily accessible online information, anecdotal evidence, or simple
luck in random investments may encourage investors to place excessive faith in their own
expertise. Overconfidence may lead investors to make risky investments. Most people tend to
overestimate their skills, whether it’s changing an electrical outlet or managing their own
finances.

Herd Mentality

The term herd instinct refers to the phenomenon where people join groups and follow the
actions of others under the assumption that other individuals have already done their research.
In financial markets, herd mentality can lead to asset bubbles, which is when the price of an
asset like a stock rises rapidly but will eventually fall, and market crashes, which occurs
when a lot of investors sell-off their stocks. Herd instincts are common in all aspects of
society, even within the financial sector, where investors follow what they perceive other
investors are doing, rather than relying on their own analysis. In other words, an investor who
exhibits herd instinct generally gravitates towards the same or similar investments as others.
Herd instinct at scale can create asset bubbles or market crashes via panic buying and panic
selling. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-
offs.

Emotional Gap

The emotional gap refers to decision making based on extreme emotions or emotional strains
such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people
do not make rational choices. For example, an investor’s desire to “get rich quick” can cause
them to make risky investments for a promise of quick returns. On the other hand, fear can
prevent investors from making sound investment decisions or entice them to prematurely sell
off assets at the first sign of trouble. Emotional gap can cause investors to make irrational
decisions based on their emotions rather than focus on hard facts and professional advice.

Anchoring

Anchoring is a heuristic in behavioural finance that describes subconscious use of irrelevant

information, such as the purchase price of a security or the estimated budget of the investor,
as a fixed reference point (or anchor) for making subsequent decisions about that security. An
anchoring bias can cause a financial market participant, such as a financial