Behavioral Finance- The Psychology of Investors and Their Emotional Biases | Intelligent Investing Greenville, SC (2024)

I think one of the major results of the psychology of decision making is that people’s attitudes and feelings about losses and gains are really not symmetric. So we really feel more pain when we lose $10,000 than we feel pleasure when we get $10,000. ~Daniel Kahneman

According to Traditional Finance, investors are, for the most part, rational “wealth maximizers.” This theory says man acts only in a way that maximizes his returns and minimizes his risks. In contrast, Behavioral Finance attempts to understand and explain actual investor behavior versus theories of investor behavior.

Emotion and deeply ingrained biases influence our decisions, causing us to behave in unpredictable or irrational ways. In fact, some may consider it to be predictably irrational.Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.

Daniel Kahneman and Amos Tversky
Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the fathers of behavioral economics/finance. Since their initial collaborations in the late 1960s, this duo has published about 200 works, most of which relate to psychological concepts with implications for behavioral finance. In 2002, Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics.

It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what is going on. ~Amos Tversky

Investors are influenced by two primary behavioralbiases: Cognitive Errors and Emotional Biases

Cognitive Errors

Cognitive Errors deal with how people think and result from memory and information-processing errors and are, therefore, the result of faulty reasoning.

There are two sets of cognitive errors: belief perseverance biases and information-processing biases.

Belief perseverance biases are those in which people have a hard time modifying their beliefs, even when faced with information to the contrary. Belief perseverance biases include cognitive dissonance, conservatism, confirmation, representativeness, illusion of control, and hindsight.

Information-processing biases are those in which people make errors in their thinking when processing information related to a financial decision.The information-processing biases include anchoring and adjustment, mental accounting, framing, availability, self-attribution, outcome, and recency.

Emotional Biases

Emotional biases are the result of reasoning influenced by feelings.

It is a very human reaction to feel mentally uncomfortable when new information contradicts information you previously held to be true–a psychological phenomenon known as cognitive dissonance. For example, two thousand years after the Greek philosopher Pythagoras proposed the world is round, Columbus was still trying to refute the common belief that it was flat by attempting to circumnavigate the globe.

Emotional biases are based on feelings rather than facts. Emotions often overpower our thinking during times of stress. All of us have likely made irrational decisions at some time in our lives. Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, regret aversion, and affinity.

Behavioral Finance in Practice

Many wealth management practitioners note that clients often go to great lengths to rationalize decisions on prior investments, especially failed investments. Moreover, people displaying this tendency might also irrationally delay unloading assets that are not generating adequate returns.

In both cases, the effects of cognitive dissonance are preventing investors from acting rationally and, in certain cases, preventing them from realizing losses for tax purposes and reallocating at the earliest opportunity. Furthermore, and perhaps even more important, the need to maintain self-esteem may prevent investors from learning from their mistakes. To ameliorate dissonance arising from the pursuit of what they perceive to be two incompatible goals— self-validation and acknowledgment of past mistakes—investors will often attribute their failures to chance rather than to poor decision making.

People who miss opportunities to learn from past miscalculations are likely to miscalculate again—renewing a cycle of anxiety, discomfort, dissonance, and denial.

Intelligent Investing wants to break this cycle, and by understanding behavioral finance, we can.

Watch more behavioral finance videos here.

Behavioral finance is one of three pillars of financial thought that we believe in. The other two are Traditional Finance and Values-Based Finance.

Behavioral Finance- The Psychology of Investors and Their Emotional Biases | Intelligent Investing Greenville, SC (2024)


What are 2 common behavioral biases that affect investors? ›

Behavioral finance can be analyzed to understand different outcomes across a variety of sectors and industries. One of the key aspects of behavioral finance studies is the influence of psychological biases. Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity tendencies.

What are the five 5 biases which people have when investing? ›

Five Behavioral Biases Affecting Investors. Here, we highlight five prominent behavioral biases common among investors. In particular, we look at loss aversion, anchoring bias, herd instinct, overconfidence bias, and confirmation bias. Loss aversion occurs when investors care more about losses than gains.

What is behavioral finance and the psychology of investing? ›

People make mistakes – even in investment decisions, which results in inefficiencies at the market level. Based on behavioral finance, investment is 80% psychology. In the meantime, behavioral finance has created methods that can help investors identify typical mistakes while finding the right portfolio for them.

Is behavioural finance easy? ›

The idea that applying behavioural finance concepts is easy is nonsense. It is far far easier to give in to our ingrained dispositions which are natural and make us feel good – that's why everyone does it. Improving our investing behaviour means going against our own instincts and often what other people are doing.

What is emotional bias in investing? ›

Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion. Understanding and detecting biases is the first step in overcoming the effect of biases on financial decisions.

What are the 6 emotional biases? ›

The six emotional biases are loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion.

What are the 10 behavioral biases? ›

Second, we list the top 10 behavioral biases in project management: (1) strategic misrepresentation, (2) optimism bias, (3) uniqueness bias, (4) the planning fallacy, (5) overconfidence bias, (6) hindsight bias, (7) availability bias, (8) the base rate fallacy, (9) anchoring, and (10) escalation of commitment.

What does the rule of 72 determine? ›

The Rule of 72 is a calculation that estimates the number of years it takes to double your money at a specified rate of return. If, for example, your account earns 4 percent, divide 72 by 4 to get the number of years it will take for your money to double. In this case, 18 years.

What are the two pillars of behavioral finance? ›

And yet, there is no dearth of investors making irrational decisions. Clearly, something else is at play here – cognitive bias and limits to arbitrage. These are the two pillars of behavioural finance. Both offer answers to how emotions and biases affect share prices and financial markets.

What is an example of behavioural finance in real life? ›

Example: Another classic example of behavioural finance in action is the tendency for investors to practice Loss Aversion. Many investors hold on to losing stocks for too long, hoping for a rebound.

What is the hardest finance job to get? ›

1. Investment Banker. Roles in investing banking are highly sought after. For investment bankers, it's often a higher competition to land a role in one of the largest firms.

What are the flaws of behavioural finance? ›

Behavioural finance theory ignores the impact of social status on investment decisions. Some investments are made only to increase social status and investors do not care about the economic impact of such investments e.g. people purchase expensive houses and other goods to to 'keep up with the Jones's'.

What is the problem with behavioral finance? ›

Reduces Confidence: Another big problem with behavioral finance theory is that it drastically reduces investor confidence. After reading these theories, many investors have reported that they face difficulties while making decisions. This is because investors start second-guessing themselves.

What are behavioral biases of investors? ›

Investing behavioral biases encompass both cognitive and emotional biases. While cognitive biases stem from statistical, information processing, or memory errors, an emotional bias stems from impulse or intuition and results in action based on feelings instead of facts.

What are the 2 main biases? ›

Implicit bias is the positive or negative attitudes, feelings, and stereotypes we maintain about members of a certain group without us being consciously aware of them. Explicit bias is the positive or negative attitudes, feelings, and stereotypes we maintain about others while being consciously aware of them.

What are the two main categories of behavioral biases? ›

Behavioral biases may be categorized as either cognitive errors or emotional biases. A single bias may, however, have aspects of both with one type of bias dominating.

What are the behavioral biases of individual investors? ›

Real traders and investors tend to suffer from overconfidence, regret, attention deficits, and trend chasing—each of which can lead to suboptimal decisions and eat away at returns. Here, we describe these four behavioral biases and provide some practical advice for how to avoid making these mistakes.


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