Advantages of Behavioral Finance

The problem with traditional financial theories is that they tend to operate in an ideal world! The underlying assumptions are that the information available is perfect, the investors are capable of interpreting the information.

Another assumption is that there is a single right answer which can be mathematically worked out. However, when investors use this theory and trade in the real world, they experience failures.

The fact of the matter is that investment markets are more about emotions than they are about rationality. This is where the science of behavioral finance comes into play.

There are several studies that indicate that the difference between successful and unsuccessful investors is not in their cognitive abilities but rather in their behavioral abilities.

In this article, we will have a closer look at behavioral finance as well as the advantages that arise because of using this philosophy to make investment decisions.

Explains Wealth as a Function of Decision Making: A lot of investors believe that they will not be able to amass wealth in the stock market because they are not highly qualified. Many of these people are doctors, engineers and know a lot about their own professions, but they tend to know less about finance. As a result, they avoid making investment decisions.

Behavioral finance explains that success in the stock market comes from managing one’s emotions rather than being a financial expert. This explains why so many finance experts struggle to make money in the markets, whereas many relatively unskilled investors end up making more money.

Theory vs. Application: Traditional finance adopts a theoretical view of how the stock market functions. People with knowledge of traditional financial theory know the mathematical models according to which the market is supposed to function.

However, in reality, markets tend to work as a voting machine. Hence, if the majority of the participants are behaving irrationally for a small period of time, the entire market will be irrational. Knowledge of behavioral finance helps an investor to see flaws in the thinking of other investors and to avoid those flaws themselves.

Explains Asset Bubbles: Traditional financial theories have been unable to explain the concept of asset bubbles. If all market participants are rational, then why do markets behave irrationally for a long period of time? How is it that sometimes people end up providing companies with a higher valuation than the entire industry!

Behavioral finance acknowledges the fact that some investors have no clue about what they are doing. Sometimes they just follow herd behavior, and this is what creates asset bubbles. Traditional finance theory cannot explain the existence of asset bubbles, but behavioral finance can. Since asset bubbles do exist and recur from time to time, and behavioral finance is the only theory that can explain them, it provides more information to the investors.

Creates Buy and Sell Opportunities: If an investor has not understood the behavioral aspects of finance, they too are likely to blindly follow the trend. This means that they are likely to sell when the markets are crashing and buy when they are booming. Investors with knowledge of behavioral finance are able to segregate the truly catastrophic events from overreactions in the market. As a result, knowledge of behavioral finance helps investors identify buying and selling opportunities in the market. The knowledge of these biases helps them to manage their emotions and think clearly, which ultimately ends up creating more wealth.

Creates Predictable Patterns: People who study behavioral finance know that people behave in certain predictable patterns. This is because they are driven by emotions.

For instance, if the sentiment prevailing in the market is that of fear, then more people are likely to sell their stock. Similarly, once the price reaches a certain threshold, there is somewhat of a rebound. Behavioral investors often use charting techniques and conduct a technical analysis to identify patterns. Once they see the patterns repeating, they are able to capitalize on them and make more money.

Helps Understand the Concept of Time Horizon: Students of behavioral finance understand that investors behave differently based on the stage of life that they are in. A young person who has several years of investing left is likely to take more risks. On the other hand, older people are more likely to sell as soon as they see a price drop.

Hence, the demographic profile of investors also has a huge impact on their behavior. Behavioral finance practitioners often study demographic profiles since it allows them to make more accurate predictions.

The fact of the matter is that traditional financial theories are not enough, and they cannot explain many phenomena that exist in the markets. Therefore, there is a need for investors to also look at the behavioral aspects which affect decision making.

At the end of the day, markets are driven by human behavior even if the behavior is irrational! Denying the facts and concentrating only on the make-believe world of financial theories where there is perfect knowledge, and everyone has the same cost of capital is bound to instigate the investors to make wrong decisions.