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Behavioral finance is a financial theory which offers an alternative to the traditional financial theory of Market Efficiency. Behavioral finance studies the role of psychology and emotions in investors’ investment decision making.

Definition

Behavioral finance argues that, contrarily to what the Efficient Market Hypothesis asserts, investment decisions are biased by cognitive factors. [1] It first states that investors are irrational because their investment decisions are mainly influenced by their emotions. Moreover, this theory states that financial markets are inefficient. Sudden stocks’ price changes are the result of speculation, which makes it possible for any investors to beat the market.

Historical Background

The theory of behavioral finance first emerged in the 1980’s when psychologist Daniel Kahneman and Economist Richard H. Thaler offered an alternative to the Efficient Market Hypothesis (EMH). They argued that investors were subjected to psychological biases. These biases contributed to investors’ irrational behavior when investing in the financial market. Since then, many economists and scholars studied the field of behavioral finance. It became particularly common after the financial crisis of 2007-2008. Indeed, this crisis demonstrated the irrationality of the financial market and pressured the Efficient Market Hypothesis assumptions.

Theoretical Evidences of Cognitive Biases

Affective Reaction

Scholars in the field of Behavioral finance studied the role of affective reactions in investment decision making [3]. They pointed out that an investor’s decision to invest in a specific financial product is based on his or her “feeling toward a particular company” [3]. As a result, an investor who has a positive feeling toward a company is very likely to invest in it, even if this investment is expected to generate negative returns. One the other hand, a negative feeling discourages investments.

Familiarity with Investments

Some studies [4] reveal that investors base their investment decisions on the degree of familiarity they have with a particular company. Familiar investment products are domestic, well-know companies, as opposed to foreign corporations which are considered as unfamiliar. Thus, a German investor is more likely to invest in a German company’s stock. The perception of risk associated with these familiar products is also altered; investors perceive domestic financial products as less risky than foreign assets.

Mass Psychology

The principle of mass psychology reveals that investors tend to follow market trends to decide whether they will buy, sell or hold a financial product [5]. This tendency confirms the role of emotions as a major driver in investment decisions. In addition, the financial market suffers from bipolar disorder because it is subjected to sudden change of mood. Bullish periods are followed by bearish periods, and investors adjust their investment behavior accordingly.

Criticism

Although behavioral finance is recognize as being a valid financial theory, some have expressed their suspicions as for its reliability. Indeed, as Stephen J. Brown [6] suggests, some investors are completely able to control their emotions and to prevent them from affecting their judgment, making the assumptions of behavioral finance irrelevant. Moreover, behavioral finance’s opponents argue that the EMH assumptions are still valid and are the foundations of most traditional financial theories.

References

[1] Kathleen Hodnett and Heng-Hsing Hsieh: Capital Market Theories: Market Efficiency Versus Investor Prospects. International Business & Economics Research Journal Vol 11 No 8, 849-862, 2012

[2] Meir Statman: What is Behavioral Finance? Handbook of Finance Vol 2 Chap 9, 2008

[3] Enrico Rubaltelli, Giacomo Passini, Rino Rumiati, Robert A. Olsen, and Paul Slovic: The Influence of Affective Reactions on Investment Decisions. Journal of Behavioral Finance Vol 11, 2010

[4] Mei Wang, Carmen Keller and Michael Siegrist: The Less You Know, the More You Are Afraid of—A survey on Risk Perceptions of Investment Products. Journal of Behavioral Finance Vol 12, 2011

[5] James H. B. Cheng: "Does Mr. Market Suffer from Bipolar Disorder?" Journal of Behavioral Finance Vol 11, 2010

[6] Stephen J. Brown: The efficient markets hypothesis: The demise of the demon of chance? Accounting & Finance, Vol 51 No 1, 2011