FAQ’s About Behavioral Finance

Behavioral finance is a fairly recent phenomenon. The development of this branch of finance is not more than a few decades old. This is the reason why there is still a lot of ambiguity about behavioral finance.

Investors still have a lot of questions about behavioral finance, which they would like to clarify. This is the reason that in this article, we will have a closer look at some of the frequently asked questions about behavioral finance.

Why is Behavioral Finance Needed?

The need for behavioral finance is felt primarily because traditional financial theories are not able to explain many of the anomalies that take place in the stock market. These anomalies are often divided into three categories.

For instance, there are some market anomalies that happen every year on a certain calendar date. These anomalies are called calendar anomalies. Market participants have observed several calendar anomalies over the years.

There have been studies conducted in order to find out why the price of a stock is higher on a certain day of the week. For instance, it has been statistically proven that stock prices are lower on Monday than on any other day.

Similarly, there are price anomalies associated with the turn of the calendar month as well as the calendar year. “December effect” and “January effect” are well-known market anomalies. According to traditional financial theories, such anomalies should not exist at all. However, they do exist because people behave differently at different times of the year.

In many other cases, the price of a stock is totally out of sync compared to certain indicators such as book value, price to earnings ratio. If the efficient market hypothesis is to be believed, such anomalies should not exist at all since the market would correct them within a few minutes.

However, such anomalies do exist and, in most cases, can be explained only via behavioral theories.

In other cases, the price of stocks reacts sharply if an earnings announcement for a particular time period is not in line with expectations. This means that it is possible to earn returns by simply observing the earnings announcement and by reacting faster to them than other participants.

Once again, this does happen, and this phenomenon cannot be explained by the efficient market hypothesis. Hence, behavioral finance is often used to make sense of such phenomenon.

Does Behavioral Finance Only Impact The Individual?

Behavioral finance theory impacts both the individual investor at the micro-level as well as the entire market at the macro level.

At the micro-level, the theories of behavioral finance are derived by comparing the assumptions of rational behavior in classical theories to the imperfect behavior exhibited by individuals in the market.

At the macro level, behavioral finance challenges and criticizes two important financial theories. One such theory is the efficient market hypothesis, and the other one is Harry Markowitz's portfolio theory.

Other theories such as the Black Scholes model as well as the Capital Asset Pricing Model also become the target of behavioral finance practitioners.

Is Behavioral Finance a Perfect Science?

Behavioral finance may or may not be considered to be a science depending upon how we define the concept of science.

In common terms, science is defined as a systematic way of looking at things and drawing valid conclusions. If this definition is considered, behavioral finance can be considered to be a science.

However, it needs to be kept in mind that behavioral finance is a social science. The whole reason behind the existence of behavioral finance is that classical financial theory makes some unrealistic assumptions.

Often, concepts of finance are straitjacketed and expressed in mathematical terms. This is not the case in behavioral finance.

The theory explains the various anomalies wherein the behavior deviates from mathematical models created by traditional finance.

Behavioral finance does not have any models of their own. This is the reason why many do not consider it to be a science.

Does Behavioral Finance Focus too much on Psychology?

Students of behavioral finance often complain that behavioral finance is less about finance and more about psychology.

Hence, they feel that even if they learn behavioral finance, they are not able to apply this science since it is not easily quantifiable.

The general perception is that behavioral finance is an abstract science which can only be used to make basic decisions.

It is true that behavioral finance focuses too much on psychology. However, that may not be a bad thing. In fact, it is this focus on psychology that gives the practitioners of behavioral finance the edge over regular investors.

Is Behavioural Finance Limited to Certain Asset Classes?

The knowledge of behavioral finance is not limited to certain asset classes. In fact, it is applicable to all investment classes. There is a common misconception that behavioral finance is only applicable to stocks and bonds. This is because most of the examples use these securities as examples.

However, the reality is that whenever humans are trying to make investment decisions, behavioral finance will be applicable.

The fact of the matter is that since behavioral finance is new, many investors still have some misconceptions about behavioral finance. Some of these misconceptions have been addressed above.