Behavioral Finance Implications On Personal Investment Decisions Finance Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Behavioral Finance - is the science that combines individual areas of economic and financial analysis with social, cognitive and emotional factors, to study and understand the processes of economic decision-making by consumers, borrowers and investors. Also, the object of interest is the impact of these factors is market price, value of a possible surcharge on the cost of goods or services, as well as the perception of price/quality, as described in What is Behavioral Finance?

It is believed that behavioral finance as a science emerged in 1985 when "Journal of Finance" published two important works devoted to studying the influence of psychological factors on the movement of stock quotes and get the investors return.

According to behavioral finance concept investors often overreacts to new information, regardless of whether it is bad or good. The result of such an overreaction is unreasonably high (does not meet the economic situation of the company) growth of quotations when the information is positive, and unreasonably low they fall, when the information is negative.  There are three situations that lead to the getting incorrect assessments and subsequently to the irrational actions. The reason that these situations are the misconceptions and preconceptions associated with it is heuristic approach to the evaluation of the data. 

1. Revaluation of available information. If a person possesses information that corresponds to the prevailing stereotype him about any events, phenomena and processes, their causes and their future implications, he begins to give this information too much (even when it is absolutely useless to make the right decisions) attention and ignore the really important factors. Very often people think that there is some relationship between events and phenomena in reality not related to each other. The consequence is an illusory correlation between the facts, which, in turn, leads to the illusion of control. A large number of different experiments proved that even if a person knows about the uselessness of the information available, it is acting on his subconscious, adjusting the process of assessing an event. 

2. Improper use of practical models of probability theory and mathematical statistics in the assessment of reliable and relevant information. Particularly relevant and appropriate are often presented estimates resulting from the application of mathematical, namely probabilistic and statistical methods. However, just here there is a significant amount of confusion that leads to unfounded conclusions. The reason is that trying to estimate the probability of occurrence of a result of several possible, people typically relies on representativeness. In this widely used average statistical data, without taking into account the fact that these results are only valid for a sufficiently large number of experiments. 

3. Influence on the assessment of ways to describe the situation and giving information (as relevant as useless). The psychology of people in the perception of the information available is that different ways of presenting data are to receive different ratings. For example, if you want to evaluate some final value based on the submitted data for visual perception, lower values will be given, where there were fewer challenges in the early numbers, as described in Behavioral finance: Applied psychology that can save money.

It can be concluded that the information which should be the most important factor in assessing the situation to make important decisions, often has the opposite effect, and the main reasons for this are as follows: 

People take the limited information in a comprehensive and adequate; 

People make available, at their disposal, information for the information truly meaningful in this case; 

People do not realize the significance of available information; 

Possession of necessary and sufficient information, people use the wrong methods for its evaluation; 

People tend to see a pattern where in fact there is a chance, as stated in Behavioral finance.

It should be noted that significant contribution in irrational behavior in the market decision-making process has emotional factors inherent in human nature itself. They force people to behave a certain way in situations where the action will inevitably manifest the characteristic factor.

In subsequent years, a large number of scientists - experts in the field of financial science, faced with the inability to explain many phenomena in financial markets in the classical theories, began to study the relationship between psychology and the problems of market behavior of investors. The main achievement of behavioral finance can be called a realization of the fact that in the areas of finance people make decisions and act under the influence of the prevailing stereotypes, illusions, perception, preconceptions, errors in the analysis of information and the most common emotions.

This is clearly illustrated by too self-confident investors. They belief that in their activities and they possess greater knowledge and skills than those possessed by the average investor. The real effect of this excessive self-confidence and abilities is very serious. One of the dangers associated with excessive self-confidence is increase in trading activity. Self-confident investors hoping to profit from what they regarded as their superior awareness, frantically buying and selling shares, even if clearly proved that a strategy based on high-speed trading, work less strategies based on acquisition and retention of shares.

In contrast to the grounds of rational behavior, which is based on the classical financial theory, behavioral finance has the following characteristics of irrational behavior, inherent in modern stock market participants. 

Investors do not adhere to the passive strategies, implicit theory of efficient markets. They are very active in buying and selling securities, often using inaccurate or outdated information, follow the "experts" advice. Investors continue use a variety of models to predict future market prices but not enough to diversify their market portfolios. 

Investors do not appreciate risky activities in accordance with the principle of maximizing expected utility. They do not objectively assess the probabilistic characteristics of the expected results because of aversion to losses and revaluation of the desired results. Also, the final result is seen not in terms of the level of final wealth, but in terms of wins and losses, compared with a threshold value that varies depending on the particular situation. 

Investors predict the future uncertain quantity (e.g. a stream of income generated by certain securities), build statistical and probabilistic models, based on information relating to short the previous period, which can not serve as a basis for applying the apparatus of probability theory and mathematical statistics. 

Investors can take a variety of investment decisions, depending on the form of problem statement (effect of registration). The most common example is a question of choosing between stocks and bonds as a long term investment object. If, for evaluating the attractiveness of bonds, the investor compares them with long-term shares, he will decide in favor of the latter, according to the results obtained for a significant period of time. If the object of alternative investments is the short-term investments in shares, then, as a rule, seem to be the most attractive bonds. 

Due to their inherent conservatism and using the heuristic rule representation, investors are either insufficient or excessive reaction that affects the pricing of financial assets and, consequently, the amount of income received by investors, as stated in Behavioral Finance Implications.

Especially clearly irrational behavior is manifested in a situation of uncertainty and risk, and which runs the entire enterprise, investment, financial activities. Very important is the fact that the influence of subjective factors identified is subject to absolutely everything, regardless of training, scope of activities and work experience. In difficult situations associated with uncertainty and risk, people behave the same way, making the same mistakes. Accounting for factors identified behavioral finance will significantly increase the efficiency of the financial strategy and tactics of market participants.

Unfortunately, today in the United States average retirement plan can not inspire confidence in people's future. As a matter of fact, today pension gives minimum interest rates for the average American that is why many people try to earn on investments in different securities. People think that they are confident and have financial literacy but, unfortunately, they do not take into account behavioral finance theory. Acting in accordance with their emotions they, in most cases, lose their money.

I think there are several solutions for this situation. First one - is to entrust money to mutual funds, when they will be operated by professionals. But this way has many disadvantages such as: lower yield compared with buying shares by yourself, the risk that the fund may burst and so on. Second way (in my opinion the most preferable) is become financial literate. I strongly believe that it means not only general knowledge about securities and current market situation but understanding and awareness what is behavioral finance and how a person could reduce the risks of emotional decision-making to a minimum.