Limitations of Behavioral Finance

The theory of behavioral finance has become exceedingly popular in the past few years. This is largely because of the fact that it mixes the dry, numerical subject of finance with the interesting world of psychology.

Most people who read about biases described in behavioral finance books often have a “me too” moment.

The biases seem quite relatable, and most investors have been victims of these biases at one point in time or another. This is the reason why investors are often easily convinced about the effectiveness of this theory.

There are many investors who swear by its efficiency and cannot stop singing it’s praises.

Many believe that this is because behavioral finance is able to explain how the market works. It offers some sense of control in a world that has become extremely volatile over an extended period of time.

However, the reality is that behavioral finance is nowhere close to perfect and has its own sets of flaws as well.

As an investor, it is important to know and understand those flaws before making decisions which are largely based on behavioral finance.

Some of the main limitations have been listed down below:

Doesn’t Provide Alternatives: The theory of behavioral finance is basically a critique of the traditional finance theory. It does a good job of disproving the traditional finance theory. Its basic premise is that a normal investor cannot be considered to be the utility-maximizing rational person that is described in traditional theories.

This is where behavioral finance is correct. However, that does not mean it provides an alternative.

There are no propositions made by behavioral finance theory. There is nothing that can be empirically tested to formulate a new theory.

As an investor, you cannot really rely on behavioral finance. This is because investments cannot be made based on criticisms.

In short behavioral finance, the theory explains everything which is wrong with traditional theories. However, it does not provide an alternative!

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.

Everything they used to believe in earlier now starts looking like a bias. Hence, they are not really sure and cannot be decisive in the given moment. It is a known fact that decisiveness is very important in investment decisions.

Investments are all about time, and by the time an investor is able to sort out their bias and gain confidence, the investment proposition may have changed completely.

Contradictory Inferences: In many cases, behavioral finance theories end up confusing investors as well. Sometimes they draw a conclusion that investors are risk-averse.

In the same theory, they draw a conclusion that investors are overconfident. Practitioners of behavioral finance try to defend their theory by saying that the same investor behaves differently under different circumstances.

However, it is highly unlikely that the same person is risk-averse as well as risk-seeking. This flies in the face of psychology as well as common sense.

Not Applicable for Institutions: Another important point to note is the fact that most of the biases mentioned in behavioral finance are only applicable to individual investors.

Hence, they would apply to the market as a whole if the entire market was run by individuals.

However, the reality is that institutional investors form the majority of the investing community in the market. They do not face most of the individual biases since they are investing other people’s money.

The behavioral finance theory is able to explain the irrational behavior of individual investors. However, it is not able to explain the irrational behavior of institutions.

Ignores Impact of Social Status: Another important point is the fact that behavioral finance theory ignores the impact of social status on investment decisions. There are some investments which are made purely from the point of view of increasing social status.

In such cases, investors do not care about the economic impact of such investments. Most real estate investments fall under this category.

People purchase expensive real estate because it gives them social status. The entire rationale behind status based investing has been missed in behavioral finance.

Disregards the Value of Emotions: Behavioral finance views emotions as biases. In other words, it views emotions as cognitive problems that need to be fixed over the long term.

However, in reality, this is not the case. Emotions have been friends of human beings for a very long time. Emotions have guided human beings away from chaos and danger. They can be very useful at times.

Investors should realize that they do not need to abandon their emotions. Instead, they should try to optimize them, i.e., take cues from them but make the final decision in a cool, rational manner.

The bottom line is that behavioral finance also has its own set of problems. Just like other fields, its limitations also need to be acknowledged and understood before making final investment decisions.