Behavioral Finance, What’s Going On?

What Is Behavioral Finance?

Investopedia defines Behavioral finance as a sub-field of behavioral economics and proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source of explanation for all types of market anomalies and, more specifically, market anomalies in the stock market, such as severe rises or falls in stock price.

Behavioral finance can be analyzed from a variety of perspectives. Stock market returns is one area of finance where psychological behaviors are often assumed to influence market outcomes and returns but there are also many different angles of observation. The purpose of classification of behavioral finance is to help understand why people make certain financial choices and how those choices can affect the markets. Within behavioral finance, it is assumed that financial participants are not perfectly rational and self-controlled but rather psychologically influenced with somewhat normal and self-controlling tendencies.

A survey conducted with several Financial Advisors produced the following results.

• Advisors are more likely to use behavioral finance in their everyday communication with clients, rather than in their portfolio construction process.

• Advisors say that the most common behavioral biases impacting their clients are recency, loss aversion and confirmation. Advisors rank loss aversion and overconfidence as their most prevalent personal biases.

• Advisors cite strengthening trust, improving clients' investment decisions and better managing expectations as the greatest benefit of behavioral finance.

We have all studied the notorious Pavlov’s dogs study, “classical conditioning”, the learning procedure in which a biologically potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). It also refers to the learning process that results from this pairing, through which the neutral stimulus comes to elicit a response (e.g. salivation).

Well, we tend to have similar reactions. Good news = Stock Market up = lets buy; or for example follow the trend, translation, everybody is buying = Let's Buy.

Now that we know what is behavioral finance , why is it important to understand it?

On the individual basis, many of the painful investments (speculations) are a consequence of our rational and fears. That is why, we should focus in diversifying our assets and making long term investments. This will reduce the anxiety created by market volatility and reduce the potential behavioral losses.

As a society, we interact with many individuals and the media in a world that is changing faster than we could ever imagine and the Pandemic has accelerated this process. Most of the bubbles and crashes are a consequence of human behavior. For example, in 1636, one of the first bubbles studied was created “the tulip mania”, after the future markets appeared, you could buy and sell tulip bulbs contracts in the market. In a matter of a few months the Tulips multiple grew to 10 times to later crash in a matter of days to levels even lower than the beginning of the rally.

This behavior has a lot to do with the word mostly used by my daughters, FOMO, yes, fear of missing out. Your friend tells you on February last year, that he bought Tesla at 90 a month ago, the price went up to 175 and it is now at 150. You feel that it is the time to buy it and make money, the stock goes up again to 175. You really like the company, bought a Tesla 3, but now some news drives the stock down and the pandemic beginning in March takes the price of the stock to 75, half of the price you paid. Does the fear make you sell the stock? Buy more? Well almost a year later the stock is trading at 800. Is it the right price? Well, I do not know. What I know is that you should invest for the long run.

FOMO, and loss aversion, are two of the most common situations that you need to work in order to be a great investor. A Financial Advisor could help you achieve your goals by minimizing the risks and understanding how to create a portfolio that is right for you.

Another tool that can help us prevent our own emotional mistakes, is the use of technology and Artificial Intelligence (AI). These help you analyze the rationale behind an investment and can reduce the impact of the fears that might arise due to volatility in the markets.

Artificial Intelligence (AI), is continually growing at a rapid rate throughout the world. The biggest benefit is that it does better work than humans do with fewer errors, and at a much quicker rate. The world is becoming very data-oriented, and analytics can be gathered from data, helping investors and traders make decisions. Machine Learning in Finance is not only about prediction but also interpretation of data both qualitative and quantitative to find out which input variables are more crucial in predicting a target variable and reducing the common mistakes led by our emotions.

It is almost impossible to predict the next bubble or crash, but in the long term if you invest in quality assets, you will have the future you are planning. Look at Warren Buffet for instance. Remember, it is not easy to assess if a stock is too high or too low, look at the other mirror, those who bet against Tesla a year ago are losing big time.

Last but not least, Let’s look at Bitcoin (BTC). All we know so far is that it is a cryptocurrency based on blockchain, invented in 2008 by an unknown person who released it as an open-source software. Many economists have declared that is a speculative bubble, some others believe that it will replace gold as a safe heaven. On January 7th 2020, the price of bitcoin was at $8,000, today it is trading at $39,000. I have to regret that I don’t own one single BTC, and yes, I have FOMO big time. But every time somebody asks me, my answer is always the same. I don’t understand the price rationale, the only understandable thing for me, is the supply and demand imbalance. If every millennial and post millennial really thinks that this is the new safe heaven, the price will continue to rise. And that’s just not enough for me to buy it. But if you think BTC will be what their followers believe it will become, why not buy some (but not a lot).