Behavioral Finance: Does Fear and Emotion Drive Financial Behavior?


Have you ever made a decision based on your emotions even though facts and statistics point you to a different choice? Maybe you offered to buy a house above the advertised price and higher than comparable home values because you believed you would miss out due to competition? Or maybe you have a fear of flying even though flying is far safer than driving? Perhaps you keep cash in a safe at home instead of a bank savings account, because you feel immediate access to your cash is more secure than the bank.

When establishing a personal investment plan, recognizing and understanding various financial theories can help develop the best plan for you. Rational based theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), assume that people, for the most part, make decisions rationally and predictably when all information is available.

However, there is a belief that rational based theories do not address all situations. The behavior finance concept sets out to answer the additional conditions through the following eight key ideas. It is believed that these contribute to irrational financial decisions and impact the financial markets. I’m sure one or more of them are familiar to you.

  1. Anchoring

Anchoring is based on the idea that our decisions are attached or “anchored” to some reference point, regardless of it being logically relevant to that decision.

Behavioral finance example:

A good example is the rule of thumb for buying an engagement ring equal to two months of salary. This has become the “standard” and it was established by the diamond industry and not based on what one can afford or not.

Emotion leads us to believe that love is valuable and therefore “worth” more. Opening a box with an engagement ring that knocks your socks off causes the fiancé to think “He loves me therefore he spent a large amount of money”.

Behavioral finance example:

Another example is investing in a stock whose price recently dropped and believing the anchoring thoughts: “buy low, sell high”, “now’s the time to invest, it will come back up”, when actually the price drop had to do with a recent change in the company’s fundamentals (i.e. loss of a large contract) and could mean that the changes will cause a lower company value.

  1. Mental Accounting

This is the concept that separating accounts based on different goals (i.e. vacations, education) will have a different and more positive effect on spending decisions.

Behavioral finance example:

This can be illustrated better with the following example: having a special “money jar” or fund set aside for a vacation or a new home, while still carrying substantial credit card debt. When actually eliminating the credit card debt will help increase savings for the vacation or new home.

Emotion leads us to believe that the separate accounts will garner success in meeting our goals and working toward something giving a sense of responsibility and self-discipline.

  1. Confirmation and Hindsight Biases

This idea is based on the saying “seeing is believing”. However, this may not always be the case, perhaps our minds allow us to see what we want to see?

Behavioral finance example:

Have you ever been formally introduced to someone after learning another’s opinion of that person and then recognized that your first impression was impacted by a preconceived notion or confirmed? The hindsight bias can be shown by the more recent example in the real estate market in 2008. For those in Arizona and many other markets around the country homeowners experienced home values dropping significantly forcing a record number of foreclosures. Many people now believe it was obvious and they should have seen it coming, however, was it?

Emotion leads us to believe that certain events were predictable or completely obvious at the onset.  We do this in an effort to find order by creating an explanation with links between cause and effect. The problem with this could lead us to erroneous links and incorrect oversimplifications.

  1. Gambler’s Fallacy

The Gambler’s Fallacy is when one erroneously believes that because an event, or series of events, just occurred that the chances for a certain random event to follow is reduced.

Behavioral finance example:

This line of thinking is incorrect as illustrated by a series of 20 coin flips. A person might predict that the next coin flip is more likely to land with the “tails” side up. Understanding probability will tell you that each coin flip is an independent event and has no bearing on future flips. Or, as illustrated with the rise and fall of a stock price, the notion to invest in a stock that has gone down 20 days in a row because the next day it just has to go up regardless of any real fundamental reasoning for the recent price decline.

Emotion leads us to believe we have some control for the next outcome and that it’s going to go our way next.

  1. Herd Behavior

This is the propensity for individuals to follow the actions of a larger group whether rational or irrational. Individually, however, most people would not necessarily make the same choice.

Behavioral finance example:

There are a couple reasons for this behavior. We as people want to be accepted by a group and therefore we are prone to follow the group even though we may make a different decision as an individual. Another, more likely, reason is the common basis that it’s unlikely that such a large group could be wrong especially in situations in which an individual has very little experience. This was seen more recently with the “dotcom” investments. At the time fundamentals were not available to support the large investments; however, because venture capitalists and private investors believed in them as good investments, then they must be, right?

Emotion leads us to believe that the masses are right and since it’s different from what I think, I must be wrong. These beliefs come from self-doubt and insecurity.

  1. Overconfidence

Confidence versus overconfidence. Confidence implies realistically trusting in someone or something, while overconfidence usually suggests an overly optimistic judgement of one’s knowledge or control over a situation. Another way to explain it is by referring to my personal example of bowling. Yes, I’m talking about the sport. First, I should explain that I actually don’t really enjoy the sport, typically the balls are too heavy. But, every time I play I feel that I’m getting better and after a couple rounds I actually believe I could win. This is an example of my unwarranted confidence, i.e. overconfidence.

Behavioral finance example:

Most recently we can look at the 2008 Housing Crisis. There were many variables that caused it; however, the above average increase in home values can be attributed partly to the overconfidence of real estate investors who didn’t normally refer to themselves as real estate investors. Values in their homes were increasing and opportunities to capitalize on that were marketed to them. The value increase had nothing to do with their real estate knowledge; however, it made them feel confident in their ability to invest in another and make money.

Emotion leads us to believe that ultimately, we have control of the outcome. Perhaps it comes from our belief that we are entitled to the positive result.

  1. Overreaction and the Availability Bias

Emotions in the stock market help explain overreaction when new information is presented. Based on the availability bias, people tend to weigh their decisions heavily on more recent information, making their new opinion biased toward that latest news. Perhaps you have experienced this when driving by a car accident? Immediately you slow down and drive with more attention. You may even continue to do so the next couple of times you drive, but then over time you revert back to your normal driving behavior.

Behavioral finance example:

Perhaps we are experiencing an example in today’s market? As a whole, the U.S. economy is performing well and the stock market is at an all-time high. Given this positive news, perhaps more people are investing or more dollars are being invested in the market leading to more new highs.

Emotion leads us to believe that new current information is better and more accurate and we must pay more attention to it than the previous information available. This drives us to action.

  1. Prospect Theory

Prospect Theory believes that people value gains more positively than they value losses negatively, and therefore make decisions based on these perceptions.

Behavioral finance example:

To clarify, winning $50 is better than winning $100 and then losing $50. The end result is the same – $50; however, losses have more emotional impact than an equivalent amount of gain. This theory can also be used to explain the occurrence of the disposition effect. The disposition effect is when an investor holds on to a losing stock too long or selling a winning stock before necessary. Logically it makes more sense to hold on to the winning stocks in hopes of realizing more gains and to liquidate the losing stocks to avoid further losses.

Emotion leads us to believe that losing, regardless of the amount, relative to gains is bad. Additionally, we believe we deserve awards and positive results.

Conclusion:

What does this all mean relative to you and your investment risk management? We are emotional creatures and emotional investors, and consciously or subconsciously, this causes our behavior to focus on how winning or losing will make us feel.

With these behavior finance concepts illustrated above, it is no surprise that some investors question their confidence in the financial system and aren’t sure what to do and who to trust. At Maxima Wealth Management we assist our clients in developing a plan that meets their individual needs, we offer a structured, unemotional and highly diversified investment approach addressing risk management.

To learn more about how we can help you, contact us today for a consultation!