Behavioral Finance: Understanding Investor Biases and Market Dynamics
1. Introduction to Behavioral Finance
Behavioral Finance is a research area that explains and anticipates phenomena in financial markets based on findings in behavioral research and theoretical analysis. Behavioral finance is not yet a coherent theory, but it is far more than just a collection of anomalies. Psychology + financial theory + empirical theory + experimental research = behavioral finance.
Key Concepts:
- Momentum strategies: buying stocks that have had past high returns, and short selling stocks that have had past low returns.
- Home bias: a condition in which investors prefer and overweight domestic securities.
- Bubble: a historical run-up in the stock market, or a runaway market in which rationality has temporarily disappeared.
2. Judgment Biases
2.1 Overconfidence
Definition: Investors are overconfident. Decision-makers are too sure concerning their abilities, their knowledge, and future market prices. Overconfidence measure: percentage of true values that fall outside the confidence interval. Alternative definition: overestimation of one’s actual performance, overplacement of one’s performance relative to the average effect, excessive precision in one’s belief.
Overconfidence is due to:
- Intervals too tight: miscalibration: the length interval depends on the personal level of knowledge. Confidence intervals are usually too tight. Volatilities are underestimated.
- Biased self-assessment: when you overestimate, you underperform, and you trade too much.
Does overconfidence matter? Researchers have offered overconfidence as an explanation for: entrepreneurial failures, suboptimal investor behavior, and suboptimal corporate decisions.
2.2 Framing
Their price and return estimates are influenced by framing.
Forecast framing hypothesis: In comparison to direct return forecasts, price forecasts are distorted in the direction of mean-reverting expectations.
The elicitation mode seems to affect the result; however, other things are also different. A clean test of the effects of elicitation mode is still missing. Analysis of whether individual expectations of stock returns are influenced by the specific elicitation mode.
Summary of results: Highly significant framing effect. Confirmation of hypothesis. Upward sloping time series: return forecasts given by investors in the return forecast mode are significantly higher than those stated by investors in the price forecast mode. Downward sloping: return forecasts given by investors in the return forecast mode are significantly lower than those stated by investors in the price forecast mode.
3. Investor Behavior
3.1 Performance
Investors buy stocks that underperform the ones they sell: Average return of purchases > Average return on sales. On average, individual investors cannot beat the market: Net annual return of market > Net annual return of portfolio.
3.2 Excessive Trading
Overconfident traders base their decisions on confidence intervals which are too narrow. Overconfidence: there is a huge gap between the seller interval and the buyer interval. No overconfidence: there is no gap between the seller and buyer interval. Consequence of overconfidence: trade more aggressively and higher volume of trading. Studies from surveys and the lab try to establish a direct relationship between overconfidence and trading activity. A study combined naturally-occurring data with information from a survey. Used trading data from online brokerage accounts and psychometric data obtained from the same group of investors who responded to an online questionnaire. Various measures of trading activity were correlated with a number of metrics of overconfidence. Solid evidence that those who were most subject to the better-than-average effect traded the most.
3.3 Disposition Effect
Investors tend to: sell winners too early and ride losers too long. The prices on the buying may influence the buying and selling patterns. The purchase price may influence selling patterns. Risk seekers hold the stock when they have a loss. Risk-averse sell the stock when they have gains. Risk-prone = convex. Risk-averse = concave.
Prospect theory: reference point (gain & losses). Gain/loss. Special value function: v, different risk behavior. Probability transformation, risk aversion = gain, risk taker = loss. Expected utility: no reference point. Total wealth. Utility function. No probability transformation.
Empirical evidence: According to reality, PRG is significantly higher than PRL. 1) Not only pay attention to behavioral factors. 2) Difficult to identify cause and effect. According to rationality, PRG = PRL.
There is a need to complement this assumption with experiments. Hypotheses: (1) Subjects sell more shares if they are winners than if they are losers. (2) Disposition effects are smaller if assets are automatically sold as if selling is deliberate. Hypothesis 1: Sold stocks are 60% winners & 40% losers, although a rational strategy is to buy winners & sell losers. Hypothesis 2: Through the automatic selling of all assets and potential rebuying of assets, the disposition effect is reduced.
Experimental research on financial markets: examine a phenomenon which is relevant for financial markets in a simple artificial environment. (1) Classic field data (2) Field experiments (3) Lab experiments. Interaction between the three. Downward is Internal validity: the true causes of the outcomes that you observed in your study. Strong internal validity means that you have a strong justification that causally links your independent variables to your dependent variables. Upward is External validity: addresses the ability to generalize a research result to other people & other situations.
3.4 Portfolio Diversification
Portfolio structure: Investors typically hold overly risky portfolios. Investors’ Problems: (1) Diversification: have stocks of only a few companies in their portfolio. (2) Home bias: prefer domestic stocks. (3) Risk-seeking: tend to invest in risky industries.
(1) Diversification: the percentage of investors’ portfolios decreases with the number of different stocks owned. Most investors are under-diversified. The high idiosyncratic risk in investors’ portfolios results in a welfare loss. Under-diversification is more pronounced among younger, low-income, less-educated & less-sophisticated investors.
(2) Home bias: portfolio holdings are biased towards domestic stocks. Individuals hold too little of their wealth in foreign assets. A domestic portfolio is not efficient: international diversification leads to: higher expected return at the same risk &/or lower risk at the same expected return. International markets are not perfectly correlated. Correlations tend to increase, but at the time new investment opportunities arise. Home-biased owners forego diversification benefits. Potential explanations: (1) Excessive optimism about the prospects of the domestic market. (2) Comfort-seeking and familiarity; what is familiar is good. (3) Institutional restrictions: capital movement restrictions, differential trading costs, differential tax rates. (4) The latter likely plays a very minor role. (5) Informational advantage: a rational explanation for local preference is informational advantage: you know more about what is close. Gains from being local to a company may appear in improved monitoring capability and access to private information.
Potential explanations: (1) Excessive optimism about the prospects of the domestic market. (2) Comfort-seeking and familiarity; what is familiar is good. (3) Institutional restrictions: capital movement restrictions, differential trading costs, differential tax rates. (4) The latter likely plays a very minor role. (5) Informational advantage: a rational explanation for local preference is informational advantage: you know more about what is close. Gains from being local to a company may appear in improved monitoring capability and access to private information.
4. The Effect of Financial Literacy
Professional investors seem to be much more rational. However, we will see that financial literacy only weakens these effects. Financial literacy enables people to make informed and confident decisions regarding all aspects of budgeting, spending, saving & banking, as well as borrowing, investing, or planning for the future.
Measurement: (1) Questionnaires: short-scale. (2) Univariate measures: different interpretations. Which aspects are relevant? (1) Institutional knowledge: know by heart. (2) Mathematical abilities: is it the core of financial literacy, or is it separate? (3) Economics and finance knowledge: concepts.
5. Implications for Regulation, Education, and Clients
Swedish Research: Workers invest in an individual saving account; it is a % of the salary. Workers are allowed to choose the pension fund that best suits their investment preferences. Not actively choose. Participants were actively encouraged to choose their own portfolios, select up to 5 funds from 456 funds. There are 2 pages of information on every fund. Default fund for a diversified portfolio, low fees & small home bias.
Approaches to the regulation of Financial Markets: (1) Liberalism: enable people to make better decisions, increase the level of financial literacy, free choice. The government does not help. Better-informed investors then better performance. (2) Strong regulation: Key Investor Information Document, ban on short selling, banning dangerous financial products. (3) Intermediate way: a combination of both. Free choice with a default solution or fund. People with a lower level of wealth, financial literacy, or more need for help end up in the default fund.