Behavioral finance: the impact of cognitive biases

Behavioral finance is a field of research that aims to measure the influence of psychology, and more specifically cognitive biases, on market finance. Behavioral finance helps to explain certain unpredictable investor behaviors, nuancing or even contradicting the idea that financial markets obey perfectly rational behavioral skills. Would you like to acquire solid skills in behavioral and operational finance to join a leading company or financial institution? Find out more about our Master of Science (MSc) program.

What is behavioral finance?

Behavioral finance is a sub-field of behavioral economics, which deals with the influence of human behavior on certain economic situations (consumption choices, investment, savings, etc.).

Behavioral finance tends to demonstrate that certain psychological influences and prejudices affect investors' financial behavior, and can explain various types of anomalies, particularly on stock markets, such as sharp rises or falls in share prices. Behavioral finance takes the view that investors are not always rational, that they do not always control their own actions, and that they obey their own prejudices.

Behavioral finance is seen as opposed to traditional financial theory, which assumes that markets and investors are perfectly rational. The basic premise of behavioral finance is that individuals are “normal” rather than “rational”, and are therefore subject to perfectly human cognitive biases, i.e. misleading and falsely logical thought patterns.

What is the aim of behavioral finance?

The aim of behavioral finance is to help us understand why investors make certain financial choices, and how these choices can affect the markets. It helps avoid emotional speculation leading to losses - as many investors buy when the stock is already too high and sell as soon as it starts to fall - and thus facilitates the choice of an appropriate wealth management strategy.

Behavioral finance theories are also very useful for understanding how investors position themselves. What is their relationship to risk? What kind of products do they want to invest in? To sell more, financial institutions need to know exactly what investors want. In this sense, behavioral finance proves to be a formidable tool for making recommendations tailored to investors' preferences, and thus selling more.

Cognitive biases in behavioral finance

Behavioral finance studies how cognitive biases influence financial decisions. Confirmation bias leads investors to seek out information that confirms their beliefs, ignoring information that contradicts them. Risk aversion makes them feel the pain of losses more strongly than the pleasure of gains, leading to cautious decisions or the retention of losing investments. The recency effect means that investors rely more on recent events than on historical data. Anchoring bias influences decisions based on initial information, such as the initial purchase price. Overconfidence leads investors to overestimate their forecasting abilities, thereby taking excessive risks. Finally, the group effect leads investors to follow the majority, creating speculative bubbles and crashes. Understanding these biases enables us to make more informed financial decisions.

What impact does behavioral finance have on market volatility?

The theory of financial market efficiency formalizes the idea that the prices of financial securities do not follow random variations, but evolve rationally according to the economic information available. This theory is generally based on the conviction that investors consider the price of a share rationally in relation to all the intrinsic (sales, market share, etc.) and extrinsic (global economic context, interest rates, etc.) factors specific to the issuing company.

However, numerous studies contradict this vision of an efficiently self-controlled market. Behavioral finance argues that many psychological and social factors can influence the buying and selling of shares, and hence their price. The understanding and use of behavioral finance biases can be applied on a daily basis to stock market movements.

Generally speaking, behavioral finance theories are used to provide clearer explanations of major market anomalies, such as speculative bubbles and deep recessions. Investors and portfolio managers have every interest in understanding the mechanics of behavioral finance in order to analyze and anticipate market price fluctuations, whether they are seeking to speculate, protect themselves or fine-tune their decision-making.

Famous examples of behavioral finance

A well-known example of behavioral finance is the “herd effect”, also known as the “herd instinct”: this consists of an individual imitating the behavior or actions of a larger group. Social pressure leads us to conform to the decisions of others, with the idea that the majority can't be wrong, as when we prefer to choose a full and noisy restaurant rather than an empty one. The coronavirus pandemic first affected the real economy for rational reasons (disruption of production, drop in consumption, etc.), before suddenly causing the stock markets to collapse for no real reason, simply because traders got scared.

It has also been proven that individuals value losses more than gains, which leads some investors to limit risk-taking and settle for low-return investments. Buying a product you don't need during a sale, but which gives you the feeling you're making money because it's offered at a reduced price, is also the consequence of a cognitive bias in behavioral finance.