Behavioural finance is a new way of looking at finance keeping in mind that humans are, in fact, emotional beings and prone to taking mental shortcuts that may cause errors in judgments (commonly known as heuristics). It attempts to use psychology in order to explain the seemingly irrational behaviour in the marketplace.
This seems fairly obvious…
It’s really not. There is an ongoing debate going on about the validity of behavioural finance, which took off from about 1980 and is now a massive interdisciplinary field including finance, psychology, experimental economics, behavioural economics and sociology.
What kind of a debate?
Essentially something that goes like this:
Old school finance people: Investors are completely rational and think with their head all the time and make wise decisions.
New age behavioural peeps: Actually, investors are human beings who sometimes make the wrong choices due to emotions and mental errors. This causes mispricing in the market (products such as stocks and bonds are overpriced or underpriced).
Old school finance people: If there is mispricing due to these “emotional investors”, won’t the rational ones in the mix of investors try and to earn riskless profit (otherwise known as arbitrage)?
New age behavioural peeps: Well, no, because:
- There are very few rational investors in the marketplace.
- Among these, even fewer have the resources to play the long con (rational investors tend to limit themselves to short term profits, as is wise due to the fickleness of the market).
- There are transaction costs that reduce the profits they would earn.
- Rational investors may not necessarily be skilled investors; their tools may produce bad models and they end up making the wrong choices.
Old school finance people: You’re basing this on studies that were made in the late 1990s. This isn’t universal. And if you’re so concerned, why aren’t you putting forward any solutions to these so-called “emotions”?
And so it goes.
I still don’t get it…
Here’s an example: Suppose you have two accounts, in which one is mentally kept as a retirement fund. From which of the accounts would it be easier to take money? Chances are you would pick the account that you haven’t kept aside as the retirement fund, although the end result is the same. This is a behavioural bias known as mental accounting, where you have multiple mental accounts that affect rational behaviour.
Take another example relating to mental accounting: If you had spent $100 for entertainment and $20 for clothes in a month, chances are that you would be more willing to spend on clothes in the same month than entertainment. Of course, there are other factors at play here; this is a scenario that has been largely simplified.
This is the gist of behavioural finance: Humans are emotional and sometimes make irrational decisions because of it.