Behavioral Finance: Introduction

ByAlbert Phung
By Albert Phung
According to conventional financial theory, the world and its participants are, for the
most part, rational "wealth maximizers". However, there are many instances where
emotion and psychology influence our decisions, causing us to behave in unpredictable
or irrational ways.
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.
By the end of this tutorial, we hope that you'll have a better understanding of some of
the anomalies(i.e., irregularities) that conventional financial theories have failed to
explain. In addition, we hope you gain insight into some of the underlying reasons and
biases that cause some people to behave irrationally (and often against their best
interests). Hopefully, this newfound knowledge will give you an edge when it comes to
making financial decisions.

Behavioral Finance: Anomalies

ByAlbert Phung
By Albert Phung
The presence of regularly occurring anomalies in conventional economic theory was a big
contributor to the formation of behavioral finance. These so-called anomalies, and their continued
existence, directly violate modern financial and economic theories, which assume rational and logical
behavior. The following is a quick summary of some of the anomalies found in the financial literature.
January Effect
The January effect is named after the phenomenon in which the average monthly return for small
firms is consistently higher in January than any other month of the year. This is at odds with the
efficient market hypothesis, which predicts that stocks should move at a "random walk". (For related
reading, see the Financial Concepts tutorial.)
However, a 1976 study by Michael S. Rozeff and William R. Kinney, called "Capital Market

Seasonality: The Case of Stock Returns", found that from 1904-74 the average amount of January
returns for small firms was around 3.5%, whereas returns for all other months was closer to 0.5%.
This suggests that the monthly performance of small stocks follows a relatively consistent pattern,
which is contrary to what is predicted by conventional financial theory. Therefore, some
unconventional factor (other than the random-walk process) must be creating this regular pattern.
One explanation is that the surge in January returns is a result of investors selling loser stocks in
December to lock in tax losses, causing returns to bounce back up in January, when investors have
less incentive to sell. While the year-end tax selloff may explain some of the January effect, it does
not account for the fact that the phenomenon still exists in places where capital gains taxes do not
occur. This anomaly sets the stage for the line of thinking that conventional theories do not and
cannot account for everything that happens in the real world. (To read more, see A Long-Term
Mindset Meets Dreaded Capital Gains Tax.)
The Winner's Curse
One assumption found in finance and economics is that investors and traders are rational enough to
be aware of the true value of some asset and will bid or pay accordingly.
However, anomalies such as the winner's curse - a tendency for the winning bid in an auction setting
to exceed the intrinsic value of the item purchased - suggest that this is not the case.
Rational-based theories assume that all participants involved in the bidding process will have access
to all relevant information and will all come to the same valuation. Any differences in the pricing
would suggest that some other factor not directly tied to the asset is affecting the bidding.
According to Richard Thaler's 1988 article on winner's curse, there are two primary factors that
undermine the rational bidding process: the number of bidders and the aggressiveness of bidding.
For example, the more bidders involved in the process means that you have to bid more aggressively
in order to dissuade others from bidding. Unfortunately, increasing your aggressiveness will also
increase the likelihood in that your winning bid will exceed the value of the asset.
Consider the example of prospective homebuyers bidding for a house. It's possible that all the
parties involved are rational and know the home's true value from studying recent sales of
comparative homes in the area. However, variables irrelevant to the asset (aggressive bidding and
the amount of bidders) can cause valuation error, oftentimes driving up the sale price more than 25%
above the home's true value. In this example, the curse aspect is twofold: not only has the winning
bidder overpaid for the home, but now that buyer might have a difficult time securing financing. (For
related reading, see Shopping For A Mortgage.)
Equity Premium Puzzle
An anomaly that has left academics in finance and economics scratching their heads is the equity
premium puzzle. According to the capital asset pricing model (CAPM), investors that hold riskier
financial assets should be compensated with higher rates of returns. (For more insight,

see Determining Risk And The Risk Pyramid.)

Studies have shown that over a 70-year period, stocks yield average returns that exceed government
bond returns by 6-7%. Stock real returns are 10%, whereas bond real returns are 3%. However,
academics believe that an equity premium of 6% is extremely large and would imply that stocks are
considerably risky to hold over bonds. Conventional economic models have determined that this
premium should be much lower. This lack of convergence between theoretical models and empirical
results represents a stumbling block for academics to explain why the equity premium is so large.
Behavioral finance's answer to the equity premium puzzle revolves around the tendency for people to
have "myopic loss aversion", a situation in which investors - overly preoccupied by the negative
effects of losses in comparison to an equivalent amount of gains - take a very short-term view on an
investment. What happens is that investors are paying too much attention to the shortterm volatility of their stock portfolios. While it is not uncommon for an average stock to fluctuate a
few percentage points in a very short period of time, a myopic (i.e., shortsighted) investor may not
react too favorably to the downside changes. Therefore, it is believed that equities must yield a highenough premium to compensate for the investor's considerable aversion to loss. Thus, the premium
is seen as an incentive for market participants to invest in stocks instead of marginally safer
government bonds.
Conventional financial theory does not account for all situations that happen in the real world. This is
not to say that conventional theory is not valuable, but rather that the addition of behavioral finance
can further clarify how the financial markets work.

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Behavioral Finance: Key Concepts Anchoring

ByAlbert Phung

By Albert Phung
In the following section, we'll explore eight key concepts that pioneers in the field of behavioral
finance have identified as contributing to irrational and often detrimental financial decision making.
As you read through them, consider whether you've fallen prey to some of these biases. Chances
are, at one point or another, we all have.
Key Concept No.
1. Anchoring
Similar to how a house should be built upon a good, solid foundation, our ideas and opinions should
also be based on relevant and correct facts in order to be considered valid. However, this is not
always so. The concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a
reference point - even though it may have no logical relevance to the decision at hand.
Although it may seem an unlikely phenomenon, anchoring is fairly prevalent in situations where
people are dealing with concepts that are new and novel.
A Diamond Anchor
Consider this classic example: Conventional wisdom dictates that a diamond engagement ring
should cost around two months' worth of salary. Believe it or not, this "standard" is one of the most
illogical examples of anchoring. While spending two months worth of salary can serve as a
benchmark, it is a completely irrelevant reference point created by the jewelry industry to maximize
profits, and not a valuation of love.
Many men can't afford to devote two months of salary towards a ring while paying for living
expenses. Consequently, many go into debt in order to meet the "standard". In many cases, the
"diamond anchor" will live up to its name, as the prospective groom struggles to keep his head above
water in a sea of mounting debt.
Although the amount spent on an engagement ring should be dictated by what a person can afford,
many men illogically anchor their decision to the two-month standard. Because buying jewelry is a
"novel" experience for many men, they are more likely to purchase something that is around the
"standard", despite the expense. This is the power of anchoring.
Academic Evidence
Admittedly, the two-month standard used in the previous example does sound relatively plausible.
However, academic studies have shown the anchoring effect to be so strong that it still occurs in
situations where the anchor is absolutely random.
In a 1974 paper entitled "Judgment Under Uncertainty: Heuristics And Biases", Kahneman and
Tversky conducted a study in which a wheel containing the numbers 1 though 100 was spun. Then,
subjects were asked whether the percentage of U.N. membership accounted for by African countries

was higher or lower than the number on the wheel. Afterward, the subjects were asked to give an
actual estimate. Tversky and Kahneman found that the seemingly random anchoring value of the
number on which the wheel landed had a pronounced effect on the answer that the subjects gave.
For example, when the wheel landed on 10, the average estimate given by the subjects was 25%,
whereas when the wheel landed on 60, the average estimate was 45%. As you can see, the random
number had an anchoring effect on the subjects' responses, pulling their estimates closer to the
number they were just shown - even though the number had absolutely no correlation at all to the
question.
Investment Anchoring
Anchoring can also be a source of frustration in the financial world, as investors base their decisions
on irrelevant figures and statistics. For example, some investors invest in the stocks of companies
that have fallen considerably in a very short amount of time. In this case, the investor is anchoring on
a recent "high" that the stock has achieved and consequently believes that the drop in price provides
an opportunity to buy the stock at a discount.
While, it is true that the fickleness of the overall market can cause some stocks to drop substantially
in value, allowing investors to take advantage of this short- term volatility. However, stocks quite often
also decline in value due to changes in their underlying fundamentals.
For instance, suppose that XYZ stock had very strong revenue in the last year, causing its share
price to shoot up from $25 to $80. Unfortunately, one of the company's major customers, who
contributed to 50% of XYZ's revenue, had decided not to renew its purchasing agreement with XYZ.
This change of events causes a drop in XYZ's share price from $80 to $40.
By anchoring to the previous high of $80 and the current price of $40, the investor erroneously
believes that XYZ is undervalued. Keep in mind that XYZ is not being sold at a discount, instead the
drop in share value is attributed to a change to XYZ's fundamentals (loss of revenue from a big
customer). In this example, the investor has fallen prey to the dangers of anchoring.
Avoiding Anchoring
When it comes to avoiding anchoring, there's no substitute for rigorous critical thinking. Be especially
careful about which figures you use to evaluate a stock's potential. Successful investors don't just
base their decisions on one or two benchmarks, they evaluate each company from a variety of
perspectives in order to derive the truest picture of the investment landscape.
For novice investors especially, it's never a bad idea to seek out other perspectives. Listening to a
few "devil's advocates" could identify incorrect benchmarks that are causing your strategy to fail.

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Behavioral Finance: Key Concepts - Mental

Accounting
ByAlbert Phung
By Albert Phung
Key Concept No.2: Mental Accounting
Mental accounting refers to the tendency for people to separate their money into separate accounts
based on a variety of subjective criteria, like the source of the money and intent for each account.
According to the theory, individuals assign different functions to each asset group, which has an
often irrational and detrimental effect on their consumption decisions and other behaviors.
Although many people use mental accounting, they may not realize how illogical this line of thinking
really is. For example, people often have a special "money jar" or fund set aside for a vacation or a
new home, while still carrying substantial credit card debt. (For more insight, see Digging Out Of
Personal Debt.)
In this example, money in the special fund is being treated differently from the money that the same
person is using to pay down his or her debt, despite the fact that diverting funds from debt repayment
increases interest payments and reduces the person's net worth. Simply put, it's illogical (and
detrimental) to have savings in a jar earning little to no interest while carrying credit-card debt
accruing at 20% annually.
In this case, rather than saving for a holiday, the most logical course of action would be to use the
funds in the jar (and any other available monies) to pay off the expensive debt.
This seems simple enough, but why don't people behave this way? The answer lies with the
personal value that people place on particular assets. For instance, people may feel that money
saved for a new house or their children's college fund is too "important" to relinquish. As a result, this
"important" account may not be touched at all, even if doing so would provide added financial
benefit.
The Different Accounts Dilemma
To illustrate the importance of different accounts as it relates to mental accounting, consider this real-

life example: You have recently subjected yourself to a weekly lunch budget and are going to
purchase a $6 sandwich for lunch. As you are waiting in line, one of the following things occurs: 1)
You find that you have a hole in your pocket and have lost $6; or 2) You buy the sandwich, but as you
plan to take a bite, you stumble and your delicious sandwich ends up on the floor. In either case
(assuming you still have enough money), would you buy another sandwich? (To read more, see The
Beauty Of Budgeting.)
Logically speaking, your answer in both scenarios should be the same; the dilemma is whether you
should spend $6 for a sandwich. However, because of the mental accounting bias, this isn't so.
Because of the mental accounting bias, most people in the first scenario wouldn't consider the lost
money to be part of their lunch budget because the money had not yet been spent or allocated to
that account. Consequently, they'd be more likely to buy another sandwich, whereas in the second
scenario, the money had already been spent.
Different Source, Different Purpose
Another aspect of mental accounting is that people also treat money differently depending on its
source. For example, people tend to spend a lot more "found" money, such as tax returns and work
bonuses and gifts, compared to a similar amount of money that is normally expected, such as from
their paychecks. This represents another instance of how mental accounting can cause illogical use
of money.
Logically speaking, money should be interchangeable, regardless of its origin. Treating money
differently because it comes from a different source violates that logical premise. Where the money
came from should not be a factor in how much of it you spend - regardless of the money's source,
spending it will represent a drop in your overall wealth.
Mental Accounting In Investing
The mental accounting bias also enters into investing. For example, some investors divide their
investments between a safe investment portfolio and a speculative portfolio in order to prevent the
negative returns that speculative investments may have from affecting the entire portfolio. The
problem with such a practice is that despite all the work and money that the investor spends to
separate the portfolio, his net wealth will be no different than if he had held one larger portfolio.

Avoiding Mental Accounting

The key point to consider for mental accounting is that money is fungible; regardless of its origins or
intended use, all money is the same. You can cut down on frivolous spending of "found" money, by
realizing that "found" money is no different than money that you earned by working.
As an extension of money being fungible, realize that saving money in a low- or no-interest account

is fruitless if you still have outstanding debt. In most cases, the interest on your debt will erode any
interest that you can earn in most savings accounts. While having savings is important, sometimes it
makes more sense to forgo your savings in order to pay off debt.

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Behavioral Finance: Key Concepts Confirmation and Hindsight Bias

ByAlbert Phung
By Albert Phung
Key Concept No.3: Confirmation and Hindsight Biases
It's often said that "seeing is believing". While this is often the case, in certain situations what you
perceive is not necessarily a true representation of reality. This is not to say that there is something
wrong with your senses, but rather that our minds have a tendency to introduce biases in processing
certain kinds of information and events.
In this section, we'll discuss how confirmation and hindsight biases affect our perceptions and
subsequent decisions.
Confirmation Bias
It can be difficult to encounter something or someone without having a preconceived opinion. This
first impression can be hard to shake because people also tend to selectively filter and pay more
attention to information that supports their opinions, while ignoring or rationalizing the rest. This type
of selective thinking is often referred to as the confirmation bias.
In investing, the confirmation bias suggests that an investor would be more likely to look for
information that supports his or her original idea about an investment rather than seek out
information that contradicts it. As a result, this bias can often result in faulty decision making
because one-sided information tends to skew an investor's frame of reference, leaving them with an
incomplete picture of the situation.

Consider, for example, an investor that hears about a hot stock from an unverified source and is
intrigued by the potential returns. That investor might choose to research the stock in order to "prove"
its touted potential is real.
What ends up happening is that the investor finds all sorts of green flags about the investment (such
as growing cash flow or a low debt/equity ratio), while glossing over financially disastrous red flags,
such as loss of critical customers or dwindling markets.
Hindsight Bias
Another common perception bias is hindsight bias, which tends to occur in situations where a person
believes (after the fact) that the onset of some past event was predictable and completely obvious,
whereas in fact, the event could not have been reasonably predicted.
Many events seem obvious in hindsight. Psychologists attribute hindsight bias to our innate need to
find order in the world by creating explanations that allow us to believe that events are predictable.
While this sense of curiosity is useful in many cases (take science, for example), finding erroneous
links between the cause and effect of an event may result in incorrect oversimplifications.

For example, many people now claim that signs of the technology bubble of the late 1990s and early
2000s (or any bubble from history, such as the Tulip bubble from the 1630s or the SouthSea bubble
of 1711) were very obvious. This is a clear example of hindsight bias: If the formation of a bubble
had been obvious at the time, it probably wouldn't have escalated and eventually burst. (To learn
more, read The Greatest Market Crashes.)
For investors and other participants in the financial world, the hindsight bias is a cause for one of the
most potentially dangerous mindsets that an investor or trader can have: overconfidence. In this
case, overconfidence refers to investors' or traders' unfounded belief that they possess superior
stock-picking abilities.
Avoiding Confirmation Bias
Confirmation bias represents a tendency for us to focus on information that confirms some preexisting thought. Part of the problem with confirmation bias is that being aware of it isn't good enough
to prevent you from doing it. One solution to overcoming this bias would be finding someone to act
as a "dissenting voice of reason". That way you'll be confronted with a contrary viewpoint to examine.

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Behavioral Finance: Key Concepts Gambler's Fallacy

ByAlbert Phung
By Albert Phung
Key Concept No. 4: Gambler's Fallacy
When it comes to probability, a lack of understanding can lead to incorrect assumptions and
predictions about the onset of events. One of these incorrect assumptions is called the gambler's
fallacy.
In the gambler's fallacy, an individual erroneously believes that the onset of a certain random event is
less likely to happen following an event or a series of events. This line of thinking is incorrect
because past events do not change the probability that certain events will occur in the future.
For example, consider a series of 20 coin flips that have all landed with the "heads" side up. Under
the gambler's fallacy, a person might predict that the next coin flip is more likely to land with the
"tails" side up. This line of thinking represents an inaccurate understanding of probability because
the likelihood of a fair coin turning up heads is always 50%. Each coin flip is an independent event,
which means that any and all previous flips have no bearing on future flips.
Another common example of the gambler's fallacy can be found with people's relationship with slot
machines. We've all heard about people who situate themselves at a single machine for hours at a
time. Most of these people believe that every losing pull will bring them that much closer to the
jackpot. What these gamblers don't realize is that due to the way the machines are programmed, the
odds of winning a jackpot from a slot machine are equal with every pull (just like flipping a coin), so it
doesn't matter if you play with a machine that just hit the jackpot or one that hasn't recently paid out.
Gambler's Fallacy In Investing
It's not hard to imagine that under certain circumstances, investors or traders can easily fall prey to
the gambler's fallacy. For example, some investors believe that they should liquidate a position after
it has gone up in a series of subsequent trading sessions because they don't believe that the position
is likely to continue going up. Conversely, other investors might hold on to a stock that has fallen in
multiple sessions because they view further declines as "improbable". Just because a stock has
gone up on six consecutive trading sessions does not mean that it is less likely to go up on during

the next session.

Avoiding Gambler's Fallacy
It's important to understand that in the case of independent events, the odds of any specific outcome
happening on the next chance remains the same regardless of what preceded it. With the amount of
noise inherent in the stock market, the same logic applies: Buying a stock because you believe that
the prolonged trend is likely to reverse at any second is irrational. Investors should instead base their
decisions on fundamental and/or technical analysis before determining what will happen to a trend.

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Behavioral Finance: Key Concepts - Herd

Behavior
ByAlbert Phung
By Albert Phung
Key Concept No.5: Herd Behavior
One of the most infamous financial events in recent memory would be the bursting of the internet
bubble. However, this wasn't the first time that events like this have happened in the markets.
How could something so catastrophic be allowed to happen over and over again?
The answer to this question can be found in what some people believe to be a hardwired human
attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or
irrational) of a larger group. Individually, however, most people would not necessarily make the same
choice.
There are a couple of reasons why herd behavior happens. The first is the social pressure of
conformity. You probably know from experience that this can be a powerful force. This is because
most people are very sociable and have a natural desire to be accepted by a group, rather than be
branded as an outcast. Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group could be wrong.
After all, even if you are convinced that a particular idea or course or action is irrational or incorrect,
you might still follow the herd, believing they know something that you don't. This is especially
prevalent in situations in which an individual has very little experience.
The Dotcom Herd
Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were
frantically investing huge amounts of money into internet-related companies, even though most of
these dotcoms did not (at the time) have financially sound business models. The driving force that
seemed to compel these investors to sink their money into such an uncertain venture was the
reassurance they got from seeing so many others do the same thing.
A strong herd mentality can even affect financial professionals. The ultimate goal of a money
manager is to follow an investment strategy to maximize a client's invested wealth. The problem lies
in the amount of scrutiny that money managers receive from their clients whenever a new investment
fad pops up. For example, a wealthy client may have heard about an investment gimmick that's
gaining notoriety and inquires about whether the money manager employs a similar "strategy".
In many cases, it's tempting for a money manager to follow the herd of investment professionals.
After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn't, that money
manager can justify his poor decision by pointing out just how many others were led astray.
The Costs of Being Led Astray
Herd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy.
Investors that employ a herd-mentality investment strategy constantly buy and sell their investment
assets in pursuit of the newest and hottest investment trends. For example, if a herd investor hears
that internet stocks are the best investments right now, he will free up his investment capital and then
dump it on internet stocks. If biotech stocks are all the rage six months later, he'll probably move his
money again, perhaps before he has even experienced significant appreciation in his internet
investments.
Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction
costs, which can eat away at available profits. Furthermore, it's extremely difficult to time trades
correctly to ensure that you are entering your position right when the trend is starting. By the time a
herd investor knows about the newest trend, most other investors have already taken advantage of
this news, and the strategy's wealth-maximizing potential has probably already peaked. This means
that many herd-following investors will probably be entering into the game too late and are likely to
lose money as those at the front of the pack move on to other strategies.
Avoiding the Herd Mentality
While it's tempting to follow the newest investment trends, an investor is generally better off steering
clear of the herd. Just because everyone is jumping on a certain investment "bandwagon" doesn't
necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your

homework before following any trend.

Just remember that particular investments favored by the herd can easily become overvalued
because the investment's high values are usually based on optimism and not on the underlying
fundamentals. (For related reading, see How Investors Often Cause The Market's Problems.)

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Behavioral Finance: Key Concepts Overconfidence

ByAlbert Phung
By Albert Phung
Key Concept No.6: Overconfidence
In a 2006 study entitled "Behaving Badly", researcher James Montier found that 74% of the 300
professional fund managers surveyed believed that they had delivered above-average job
performance. Of the remaining 26% surveyed, the majority viewed themselves as average.
Incredibly, almost 100% of the survey group believed that their job performance was average or
better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of
overconfidence these fund managers exhibited.
As you can imagine, overconfidence (i.e., overestimating or exaggerating one's ability to successfully
perform a particular task) is not a trait that applies only to fund managers. Consider the number of
times that you've participated in a competition or contest with the attitude that you have what it takes
to win - regardless of the number of competitors or the fact that there can only be one winner.
Keep in mind that there's a fine line between confidence and overconfidence. Confidence implies
realistically trusting in one's abilities, while overconfidence usually implies an overly optimistic
assessment of one's knowledge or control over a situation.

Overconfident Investing
In terms of investing, overconfidence can be detrimental to your stock-picking ability in the long run.
In a 1998 study entitled "Volume, Volatility, Price, and Profit When All Traders Are Above Average",
researcher Terrence Odean found that overconfident investors generally conduct more trades than
their less-confident counterparts.
Odean found that overconfident investors/traders tend to believe they are better than others at
choosing the best stocks and best times to enter/exit a position. Unfortunately, Odean also found that
traders that conducted the most trades tended, on average, to receive significantly lower yields than
the market. (To learn more, check out Understanding Investor Behavior.)
Avoiding Overconfidence
Keep in mind that professional fund managers, who have access to the best investment/industry
reports and computational models in the business, can still struggle at achieving market-beating
returns. The best fund managers know that each investment day presents a new set of challenges
and that investment techniques constantly need refining. Just about every overconfident investor is
only a trade away from a very humbling wake-up call.

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Behavioral Finance: Key Concepts Overreaction and Availability Bias

ByAlbert Phung
By Albert Phung
Key Concept No.7: Overreaction and the Availability Bias
One consequence of having emotion in the stock market is the overreaction toward new information.
According to market efficiency, new information should more or less be reflected instantly in a
security's price. For example, good news should raise a business' share price accordingly, and that
gain in share price should not decline if no new information has been released since.

Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market
predictably overreact to new information, creating a larger-than-appropriate effect on a security's
price. Furthermore, it also appears that this price surge is not a permanent trend - although the price
change is usually sudden and sizable, the surge erodes over time.
Winners and Losers
In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in
the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns
on the New York Stock Exchange for a three-year period. From these stocks, they separated the best
35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added
to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a
representative market index for three years.
Surprisingly, it was found that the losers portfolio consistently beat the market index, while the
winners portfolio consistently underperformed. In total, the cumulative difference between the two
portfolios was almost 25% during the three-year time span. In other words, it appears that the
original "winners" would became "losers", and vice versa.
So what happened? In both the winners and losers portfolios, investors essentially overreacted. In
the case of loser stocks, investors overreacted to bad news, driving the stocks' share prices down
disproportionately. After some time, investors realized that their pessimism was not entirely justified,
and these losers began rebounding as investors came to the conclusion that the stock was
underpriced. The exact opposite is true with the winners portfolio: investors eventually realized that
their exuberance wasn't totally justified.
According to the availability bias, people tend to heavily weight their decisions toward more recent
information, making any new opinion biased toward that latest news.
This happens in real life all the time. For example, suppose you see a car accident along a stretch of
road that you regularly drive to work. Chances are, you'll begin driving extra cautiously for the next
week or so. Although the road might be no more dangerous than it has ever been, seeing the
accident causes you to overreact, but you'll be back to your old driving habits by the following week.
Avoiding Availability Bias
Perhaps the most important lesson to be learned here is to retain a sense of perspective. While it's
easy to get caught up in the latest news, short-term approaches don't usually yield the best
investment results. If you do a thorough job of researching your investments, you'll better understand
the true significance of recent news and will be able to act accordingly. Remember to focus on the
long-term picture.

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Behavioral Finance: Key Concepts - Prospect

Theory
ByAlbert Phung
By Albert Phung
Key Concept No.8: Prospect Theory
Traditionally, it is believed the net effect of the gains and losses involved with each choice are
combined to present an overall evaluation of whether a choice is desirable. Academics tend to use
"utility" to describe enjoyment and contend that we prefer instances that maximize our utility.
However, research has found that we don't actually process information in such a rational way. In
1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people
value gains and losses differently, and, as such, will base decisions on perceived gains rather than
perceived losses. Thus, if a person were given two equal choices, one expressed in terms of
possible gains and the other in possible losses, people would choose the former - even when they
achieve the same economic end result.
According to prospect theory, losses have more emotional impact than an equivalent amount of
gains. For example, in a traditional way of thinking, the amount of utility gained from receiving $50
should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end
result is a net gain of $50.
However, despite the fact that you still end up with a $50 gain in either case, most people view a
single gain of $50 more favorably than gaining $100 and then losing $50.
Evidence for Irrational Behavior
Kahneman and Tversky conducted a series of studies in which subjects answered questions that
involved making judgments between two monetary decisions that involved prospective losses and
gains. For example, the following questions were used in their study:

1. You have $1,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
Choice B: You have a 100% chance of gaining $500.
2. You have $2,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0.
Choice B: You have a 100% chance of losing $500.

If the subjects had answered logically, they would pick either "A" or "B" in both situations. (People
choosing "B" would be more risk adverse than those choosing "A"). However, the results of this study
showed that an overwhelming majority of people chose "B" for question 1 and "A" for question 2. The
implication is that people are willing to settle for a reasonable level of gains (even if they have a
reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they
can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of
gains.
It is this line of thinking that created the asymmetric value function:

This function is a representation of the difference in utility (amount of pain or joy) that is achieved as
a result of a certain amount of gain or loss. It is key to note that not everyone would have a value
function that looks exactly like this; this is the general trend. The most evident feature is how a loss
creates a greater feeling of pain compared to the joy created by an equivalent gain. For example, the
absolute joy felt in finding $50 is a lot less than the absolute pain caused by losing $50.

Consequently, when multiple gain/loss events happen, each event is valued separately and then
combined to create a cumulative feeling. For example, according to the value function, if you find
$50, but then lose it soon after, this would cause an overall effect of -40 units of utility (finding the
$50 causes +10 points of utility (joy), but losing the $50 causes -50 points of utility (pain). To most of
us, this makes sense: it is a fair bet that you'd be kicking yourself over losing the $50 that you just
found.
Financial Relevance
The prospect theory can be used to explain quite a few illogical financial behaviors. For example,
there are people who do not wish to put their money in the bank to earn interest or who refuse to
work overtime because they don't want to pay more taxes. Although these people would benefit
financially from the additional after-tax income, prospect theory suggests that the benefit (or utility
gained) from the extra money is not enough to overcome the feelings of loss incurred by paying
taxes.
Prospect theory also explains the occurrence of the disposition effect, which is the tendency for
investors to hold on to losing stocks for too long and sell winning stocks too soon. The most logical
course of action would be to hold on to winning stocks in order to further gains and to sell losing
stocks in order to prevent escalating losses.
When it comes to selling winning stocks prematurely, consider Kahneman and Tversky's study in
which people were willing to settle for a lower guaranteed gain of $500 compared to choosing a
riskier option that either yields a gain of $1,000 or $0. This explains why investors realize the gains of
winning stocks too soon: in each situation, both the subjects in the study and investors seek to cash
in on the amount of gains that have already been guaranteed. This represents typical risk-averse
behavior. (To read more, check out A Look At Exit Strategies and The Importance Of A Profit/Loss
Plan.)
The flip side of the coin is investors that hold on to losing stocks for too long. Like the study's
subjects, investors are willing to assume a higher level of risk in order to avoid the negative utility of a
prospective loss. Unfortunately, many of the losing stocks never recover, and the losses incurred
continued to mount, with often disastrous results. (Learn more! Read The Art Of Selling A Losing
Position.)

Avoiding the Disposition Effect

It is possible to minimize the disposition effect by using a concept called hedonic framing to change
your mental approach.
For example, in situations where you have a choice of thinking of something as one large gain or as
a number of smaller gains (such as finding $100 versus finding a $50 bill from two places), thinking

of the latter can maximize the amount of positive utility.

For situations where you have a choice of thinking of something as one large loss or as a number of
smaller losses (losing $100 versus losing $50 twice), framing the situation as one large loss would
create less negative utility because the marginal difference between the amount of pain from
combining the losses would be less than the total amount of pain from many smaller losses.
For situations where you have a choice of thinking as something as one large gain with a smaller
loss or a situation where you net the two to create a smaller gain ($100 and -$55, versus +$45), you
would receive more positive utility from the sole smaller gain.
Finally, for situations where you have a choice of thinking as something as one large loss with a
smaller gain or a situation where you have a smaller loss (-$100 and +$55, versus -$45), it would be
best to try to frame the situation as separate gains and losses.
Trying these methods of framing your thoughts should make your experience more positive and if
used properly, it can help you minimize the dispositional effect.

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Behavioral Finance: Conclusion

ByAlbert Phung
By Albert Phung
Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all
been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that
you can identify some of the biases, it's time to apply that knowledge to your own investing and if
need be take corrective action. Hopefully, your future financial decisions will be a bit more rational
and lot more lucrative as well.
Here is a summary of what we've covered:

Conventional finance is based on the theories which describe people for the most part
behave logically and rationally. People started to question this point of view as there have
been anomalies, which are events that conventional finance has a difficult time in explaining.

Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and
Amos Tversky, and economist, Richard Thaler.

The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts
around a reference point despite the fact that it may not have any logical relevance to the
decision at hand.

Mental accounting refers to the tendency for people to divide their money into separate
accounts based on criteria like the source and intent for the money. Furthermore, the
importance of the funds in each account also varies depending upon the money's source and
intent.

Seeing is not necessarily believing as we also have confirmation and hindsight biases.
Confirmation bias refers to how people tend to be more attentive towards new information
that confirms their own preconceived options about a subject. The hindsight bias represents
how people believe that after the fact, the occurrence of an event was completely obvious.

The gambler's fallacy refers to an incorrect interpretation of statistics where someone

believes that the occurrence of a random independent event would somehow cause another
random independent event less likely to happen.

Herd behavior represents the preference for individuals to mimic the behaviors or actions of a
larger sized group.

Overconfidence represents the tendency for an investor to overestimate his or her ability in
performing some action/task.

Overreaction occurs when one reacts to a piece of news in a way that is greater than actual
impact of the news.

Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially
determined that people do not encode equal levels of joy and pain to the same effect. The
average individuals tend to be more loss sensitive (in the sense that a he/she will feel more
pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of
gain).

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Behavioral Finance
3

WHAT IT IS:
Behavioral finance combines social and psychological theory with financial theory as a means
of understanding how price movements in the securities markets occur independent of any
corporate actions.

HOW IT WORKS (EXAMPLE):

Suppose a lawsuit is brought against a tobacco company. Investors know that when this has
happened before, the share price of the tobacco company has fallen. With this in mind, many
investors sell off their holdings in the company. This selling results in the further decline of the
security's value.
Investors in other tobacco companies may fear similar lawsuits knowing that such a lawsuit was
brought against one tobacco company. These investors may sell off their holdings for fear of
loss. The securities prices of other companies in the industry consequently decline as well.
All the while, none of these tobacco companies took any action or had a judgment against them
that intrinsically lessened their worth. This is the sort of issue that behavioral finance attempts to
explain.

WHY IT MATTERS:
Anyone knowledgeable in financial market understands that there are numerous variables that
affect prices in the securities markets. Investors decisions to buy or sell may have a more
distinct marginaffect impact on market value than favorable earnings or promising products.
The role of behavioral finance is to help market analysts and investors understand price
movements in the absence of any intrinsic changes on the part of companies or sectors.

Behavioral economics
From Wikipedia, the free encyclopedia

Behavioral economics, along with the related sub-field, behavioral finance, studies the effects
of psychological, social, cognitive, and emotional factors on the economicdecisions of individuals
and institutions and the consequences for market prices, returns, and the resource allocation.
[1]
Behavioral economics is primarily concerned with thebounds of rationality of economic
agents. Behavioral models typically integrate insights
from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models
cover a range of concepts, methods, and fields.[2][3] Behavioral economics is sometimes discussed as
an alternative to neoclassical economics.[citation needed]
The study of behavioral economics includes how market decisions are made and the mechanisms
that drive public choice. The use of "Behavioral economics" in U.S. scholarly papers has increased
in the past few years as a recent study shows.[4]
There are three prevalent themes in behavioral finances: [5]

Heuristics: People often make decisions based on approximate rules of thumb and not strict
logic.

Framing: The collection of anecdotes and stereotypes that make up the mental emotional
filters individuals rely on to understand and respond to events.

Market inefficiencies: These include mis-pricings and non-rational decision making.

Economics

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Business and economics portal

Contents
[hide]

1History
o

1.1Prospect theory

1.2Intertemporal choice

1.3Other areas of research

2Criticism of behavioral economics

3Applied issues
o

3.1Behavioral finance

3.2Financial models

3.3Behavioral game theory

3.4Economic reasoning in non-human animals

3.5Evolutionary psychology

4Notable theorists
o

4.1Economics

4.2Psychology

4.3Finance

5See also

6Notes

7References

8External links

History[edit]
During the classical period, microeconomics was closely linked to psychology. For example, Adam
Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of
individual behavior, including concerns about fairness and justice,[6] andJeremy Bentham wrote
extensively on the psychological underpinnings of utility. However, during the development of neoclassical economics economists sought to reshape the discipline as a natural science, deducing
economic behavior from assumptions about the nature of economic agents. They developed the
concept of homo economicus, whose psychology was fundamentally rational.
However, many important neo-classical economists employed more sophisticated psychological
explanations, including Francis Edgeworth, Vilfredo Pareto, and Irving Fisher. Economic psychology
emerged in the 20th century in the works of Gabriel Tarde,[7]George Katona,[8] and Laszlo Garai.
[9]
Expected utility and discounted utility models began to gain acceptance, generating
testablehypotheses about decision making given uncertainty and intertemporal
consumption respectively. Observed and repeatable anomalies eventually challenged those
hypotheses, and further steps were taken by the Nobel prizewinner Maurice Allais, for example in
setting out the Allais paradox, a decision problem he first presented in 1953 which contradicts the
expected utility hypothesis.

Daniel Kahneman, winner of 2002 Nobel prize in economics

In the 1960s cognitive psychology began to shed more light on the brain as an information
processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward
Edwards,[10] Amos Tversky, and Daniel Kahneman began to compare their cognitive models of
decision-making under risk and uncertainty to economic models of rational behavior. In mathematical
psychology, there is a longstanding interest in the transitivity of preference and what kind of
measurement scale utility constitutes (Luce, 2000).[11]

Prospect theory[edit]
In 1979, Kahneman and Tversky wrote Prospect Theory: An Analysis of Decision Under Risk, an
important paper that used cognitive psychology to explain various divergences of economic decision
making from neo-classical theory.[12] Prospect theory has two stages, an editing stage and an
evaluation stage.
In the editing stage, risky situations are simplified using various heuristics of choice. In the
evaluation phase, risky alternatives are evaluated using various psychological principles that include
the following:

(1) Reference dependence: When evaluating outcomes, the decision maker has in mind a
"reference level". Outcomes are then compared to the reference point and classified as "gains" if
greater than the reference point and "losses" if less than the reference point.

(2) Loss aversion: Losses bite more than equivalent gains. In their 1979 paper in
Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about
2.25, i.e., losses bite about 2.25 times more than equivalent gains.

(3) Non-linear probability weighting: Evidence indicates that decision makers overweight
small probabilities and underweight large probabilities this gives rise to the inverse-S shaped
"probability weighting function".

(4) Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to
the reference point increase in absolute value, the marginal effect on the decision maker's utility
or satisfaction falls.

Prospect theory is able to explain everything that the two main existing decision theories expected
utility theory and rank dependent utility can explain. However, the converse is false. Prospect
theory has been used to explain a range of phenomena that existing decision theories have great
difficulty in explaining. These include backward bending labour supply curves, asymmetric price
elasticities, tax evasion, co-movement of stock prices and consumption etc.
In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave their revised account
of prospect theory that they called cumulative prospect theory. The new theory eliminated the editing
phase in prospect theory and focused just on the evaluation phase. Its main feature was that it
allowed for non-linear probability weighting in a cumulative manner, which was originally suggested
in John Quiggin's rank dependent utility theory.
Psychological traits such as overconfidence, projection bias, and the effects of limited attention are
now part of the theory. Other developments include a conference at theUniversity of Chicago,[13] a
special behavioral economics edition of the Quarterly Journal of Economics ("In Memory of Amos
Tversky"), and Kahneman's 2002 Nobel for having "integrated insights from psychological research
into economic science, especially concerning human judgment and decision-making under
uncertainty".[14]

Intertemporal choice[edit]
See also: Time inconsistency
Behavioral economics has also been applied to intertemporal choice. Intertemporal choice is defined
as making a decision and having the effects of such decision happening in a different time.
Intertemporal choice behavior is largely inconsistent, as exemplified by George Ainslie's hyperbolic
discounting (1975) which is one of the prominently studied observations, further developed by David
Laibson, Ted O'Donoghue, and Matthew Rabin. Hyperbolic discounting describes the tendency to
discount outcomes in near future more than for outcomes in the far future. This pattern of
discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with basic
models of rational choice, since the rate of discount between time t and t+1 will be low at time t-1,
when t is the near future, but high at time t when t is the present and time t+1 the near future.
The pattern can actually be explained through models of sub-additive discounting which
distinguishes the delay and interval of discounting: people are less patient (per-time-unit) over
shorter intervals regardless of when they occur.

Other areas of research[edit]

Other branches of behavioral economics enrich the model of the utility function without implying
inconsistency in preferences. Ernst Fehr, Armin Falk, and Matthew Rabin studied "fairness",
"inequity aversion", and "reciprocal altruism", weakening the neoclassical assumption of
"perfect selfishness." This work is particularly applicable to wage setting. Work on "intrinsic
motivation" by Gneezy and Rustichini and on "identity" by Akerlof and Kranton assumes agents
derive utility from adopting personal and social norms in addition to conditional expected utility.
According to Aggarwal (2014), in addition to behavioral deviations from rational equilibrium, markets

are also likely to suffer from lagged responses, search costs, externalities of the commons,and other
frictions making it difficult to disentangle behavioral effects in market behavior.[15]
"Conditional expected utility" is a form of reasoning where the individual has an illusion of control,
and calculates the probabilities of external events and hence utility as a function of their own action,
even when they have no causal ability to affect those external events. [16][17]
Behavioral economics caught on among the general public, with the success of books like Dan
Ariely's Predictably Irrational. Practitioners of the discipline have studied quasi-public policy topics
such as broadband mapping.[18][19]
Taxation from a behavioral economics viewpoint is illustrated in the book The Darwin Economy by
Robert H. Frank where he invokes the concept of 'positional consumption' vs 'non-positional
consumption'. Positional consumption being the consumption we do that is relative to other people
and Non-positional consumption being absolute. Good houses and good schools are essentially
positional and savings for retirement are essentially non-positional. Frank argues that since most of
our consumption is positional, tax policies must reflect that and its not possible to form coherent
societies without some form of progressive taxation.[20]

Criticism of behavioral economics[edit]

Critics of behavioral economics typically stress the rationality of economic agents.[21] They contend
that experimentally observed behavior has limited application to market situations, as learning
opportunities and competition ensure at least a close approximation of rational behavior.
Others note that cognitive theories, such as prospect theory, are models of decision making, not
generalized economic behavior, and are only applicable to the sort of once-off decision problems
presented to experiment participants or survey respondents.[citation needed]
Traditional economists are also skeptical of the experimental and survey-based techniques which
behavioral economics uses extensively. Economists typically stress revealed preferences over
stated preferences (from surveys) in the determination of economic value. Experiments and surveys
are at risk of systemic biases, strategic behavior and lack of incentive compatibility.[citation needed]
Rabin (1998)[22] dismisses these criticisms, claiming that consistent results are typically obtained in
multiple situations and geographies and can produce good theoretical insight. Behavioral
economists have also responded to these criticisms by focusing on field studies rather than lab
experiments. Some economists see a fundamental schism betweenexperimental economics and
behavioral economics, but prominent behavioral and experimental economists tend to share
techniques and approaches in answering common questions. For example, behavioral economists
are actively investigating neuroeconomics, which is entirely experimental and cannot yet be verified
in the field.[citation needed]
Other proponents of behavioral economics note that neoclassical models often fail to predict
outcomes in real world contexts. Behavioral insights can influence neoclassical models. Behavioral
economists note that these revised models not only reach the same correct predictions as the

traditional models, but also correctly predict some outcomes where the traditional models failed.
[verification needed]

According to some researchers,[23] when studying the mechanisms that form the basis of decisionmaking, especially financial decision-making, it is necessary to recognize that most decisions are
made under stress[24] because, "Stress is the nonspecific body response to any demands presented
to it".[25]
From a biological point of view, human behaviors are essentially the same during crises
accompanied by stock market crashes and during bubble growth when share prices exceed historic
highs. During those periods, most market participants see something new for themselves, and this
inevitably induces a stress response in them with accompanying changes in their endocrine profiles
and motivations. The result is quantitative and qualitative changes in behavior. An underestimation of
the role of novelty as a stressor is the primary shortcoming of current approaches for market
research. So, it is necessary to account for the biologically determined diphasisms of human
behavior in everyday low-stress conditions and in response to stressors. [23]
Behavioral economics is not focused on ethical conduct in a moral context.

Applied issues[edit]
Behavioral finance[edit]
The central issue in behavioral finance is explaining why market participants make
irrational systematic errors contrary to assumption of rational market participants.[1] Such errors affect
prices and returns, creating market inefficiencies. The study of behavioral finance also investigates
how other participants take advantage (arbitrage) of such errors and market inefficiencies.
Behavioral finance highlights inefficiencies such as under or over-reactions to information as causes
of market trends and in extreme cases of bubbles and crashes. Such reactions have been attributed
to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise
trading. Technical analysts consider behavioral finance, to be behavioral economics' "academic
cousin" and to be the theoretical basis for technical analysis.[26]
Other key observations include the asymmetry between decisions to acquire, or keep resources,
known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued
possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell
shares or other equity, if doing so would result in a nominal loss.[27] It may also help explain why
housing prices rarely/slowly decline to market clearing levels during periods of low demand.
Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity
premium puzzle, something conventional finance models have been unable to do so far.
[28]
Experimental finance applies the experimental method, e.g., creating an artificial market by some
kind of simulation software to study people's decision-making process and behavior in financial
markets.

Quantitative behavioral finance[edit]

Quantitative behavioral finance uses mathematical and statistical methodology to

understand behavioral biases. In marketing research, a study shows little evidence that escalating
biases impact marketing decisions.[29] Leading contributors include Gunduz Caginalp (Editor of
the Journal of Behavioral Finance from 200104) and collaborators including 2002 Nobelist Vernon
Smith, David Porter, Don Balenovich,[30] Vladimira Ilieva and Ahmet Duran,[31] and Ray Sturm.[32]

Financial models[edit]
Some financial models used in money management and asset valuation incorporate behavioral
finance parameters, for example:

Thaler's model of price reactions to information, with three phases (underreaction,

adjustment, and overreaction), creating a price trend,
One characteristic of overreaction is that average returns following announcements of good
news is lower than following bad news. In other words, overreaction occurs if the market
reacts too strongly or for too long to news, thus requiring adjustment in the opposite
direction. As a result, outperforming assets in one period are likely to underperform in the
following period. This also applies to customers' irrational purchasing habits.[33]

The stock image coefficient

Criticisms[edit]

Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend
that behavioral finance is more a collection of anomalies than a true branch offinance and that
these anomalies are either quickly priced out of the market or explained by appealing to market
microstructure arguments. However, individual cognitive biasesare distinct from social biases;
the former can be averaged out by the market, while the other can create positive feedback
loops that drive the market further and further from a "fair price" equilibrium. Similarly, for an
anomaly to violate market efficiency, an investor must be able to trade against it and earn
abnormal profits; this is not the case for many anomalies. [34]
A specific example of this criticism appears in some explanations of the equity premium puzzle.
It is argued that the cause is entry barriers (both practical and psychological) and that returns
between stocks and bonds should equalize as electronic resources open up the stock market to
more traders.[35] In reply, others contend that most personal investment funds are managed
through superannuation funds, minimizing the effect of these putative entry barriers. In addition,
professional investors and fund managers seem to hold more bonds than one would expect
given return differentials.

Behavioral game theory[edit]

Main article: Behavioral game theory

Behavioral game theory, Invented by Colin Camerer, analyzes interactive strategic decisions and
behavior using the methods of game theory,[36] experimental economics, andexperimental
psychology. Experiments include testing deviations from typical simplifications of economic
theory such as the independence axiom[37] and neglect of altruism,[38]fairness,[39] and framing
effects.[40] On the positive side, the method has been applied to interactive learning

Ho, Teck H. (2008). "Individual learning in games". in Palgrave and social preferences.[41] As
a research program, the subject is a development of the last three decades. [42]

Economic reasoning in non-human animals[edit]

A handful of comparative psychologists have attempted to demonstrate quasi-economic
reasoning in non-human animals. Early attempts along these lines focus on the behavior
of rats and pigeons. These studies draw on the tenets of comparative psychology, where the
main goal is to discover analogs to human behavior in experimentally-tractable non-human
animals. They are also methodologically similar to the work of Ferster and Skinner.
[43]
Methodological similarities aside, early researchers in non-human economics deviate
from behaviorism in their terminology. Although such studies are set up primarily in an operant
conditioning chamber, using food rewards for pecking/bar-pressing behavior, the researchers
describe pecking and bar pressing not in terms of reinforcement and stimulusresponse
relationships, but instead in terms of work, demand, budget, and labor. Recent studies have
adopted a slightly different approach, taking a more evolutionary perspective, comparing
economic behavior of humans to a species of non-human primate, the capuchin monkey.[44]
Non-human animal studies[edit]

Many early studies of non-human economic reasoning were performed on rats and pigeons in
an operant conditioning chamber. These studies looked at things like peck rate (in the case of
the pigeon) and bar-pressing rate (in the case of the rat) given certain conditions of reward.
Early researchers claim, for example, that response pattern (pecking/bar pressing rate) is an
appropriate analogy to human labor supply.[45] Researchers in this field advocate for the
appropriateness of using animal economic behavior to understand the elementary components
of human economic behavior.[46] In a paper by Battalio, Green, and Kagel (1981, p 621), [45] they
write

Space considerations do not permit a detailed discussion of the reason

behavior of nonhumans.

Labor supply[edit]

The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons
are first deprived of food. Since the animals are hungry, food becomes highly desired. The
pigeons are placed in an operant conditioning chamber and through orienting and exploring the

environment of the chamber they discover that by pecking a small disk located on one side of
the chamber, food is delivered to them. In effect, pecking behavior becomes reinforced, as it is
associated with food. Before long, the pigeon pecks at the disk (or stimulus) regularly.
In this circumstance, the pigeon is said to "work" for the food by pecking. The food, then, is
thought of as the currency. The value of the currency can be adjusted in several ways, including
the amount of food delivered, the rate of food delivery and the type of food delivered (some
foods are more desirable than others).
Economic behavior similar to that observed in humans is discovered when the hungry pigeons
stop working/work less when the reward is reduced. Researchers argue that this is similar
to labor supply behavior in humans. That is like humans (who, even in need, will only work so
much for a given wage) the pigeons demonstrate decreases in pecking (work) when the reward
(value) is reduced.[45]
Demand[edit]

In human economics, a typical demand curve has negative slope. This means that as the price
of a certain good increases, the amount that consumers are willing to purchase decreases.
Researchers studying the demand curves of non-human animals, such as rats, also find
downward slopes.
Researchers have studied demand in rats in a manner distinct from studying labor supply in
pigeons. Specifically, say we have experimental subjects, rats, in an operant chamber and we
require them to press a lever to receive a reward. The reward can be either food (reward
pellets), water, or a commodity drink such as cherry cola. Unlike previous pigeon studies, where
the work analog was pecking and the monetary analog was reward, in the studies on demand in
rats, the monetary analog is bar pressing. Under these circumstances, the researchers claim
that changing the number of bar presses required to obtain a commodity item is analogous to
changing the price of a commodity item in human economics. [47]
In effect, results of demand studies in non-human animals are that, as the bar-pressing
requirement (cost) increases, the animal presses the bar the required number of times less often
(payment).

Evolutionary psychology[edit]
See also: Evolutionary economics
An evolutionary psychology perspective is that many of the seeming limitations in rational choice
can be explained as being rational in the context of maximizing biological fitnessin the ancestral
environment but not necessarily in the current one. Thus, when living at subsistence level where
a reduction of resources may have meant death it may have been rational to place a greater
value on losses than on gains. It may also explain differences between groups such as males
being less risk-averse than females since males have more variable reproductive success than
females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males

may potentially increase their reproductive success much more than females from successful
risk-seeking.[48]

Behavioral finance

Also found in: Acronyms, Wikipedia.

Behavioral finance
An important subfield of finance. Behavioral finances uses insights from the field of pyschology and applies them toth
e actions of individuals in trading and other financial applications.
Copyright 2012, Campbell R. Harvey. All Rights Reserved.

Behavioral Finance
A theory of finance that attempts to explain the decisions of investors by viewing them as rational
actors lookingout for their self-interest, given the sometimes inefficient nature of the market. Tracing its origins to A
dam
Smith'sThe Theory of Moral Sentiments, one of its primary observations holds that investors (and people in general)
makedecisions on imprecise impressions and beliefs rather than rational analysis. A second observation states that t
heway a question or problem is framed to an investor will influence the decision he/she ultimately makes. These twoo
bservations largely explain market inefficiencies; that is, behavior finance holds that markets are sometimesinefficient
because people are not mathematical equations. Behavioral finance stands in stark contrast to theefficient markets
theory. See also: Naive diversification, Formula plan, Subjective probabilities.
Farlex Financial Dictionary. 2012 Farlex, Inc. All Rights Reserved

Behavioral finance.
Behavioral finance combines psychology and economics to explain why and how investors act and to analyze how th
atbehavior affects the market.
Behavioral finance theorists point to the market phenomenon of hot stocks and bubbles, from the Dutch tulip bulb ma
niathat caused a market crash in the 17th century to the more recent examples of junk bonds in the 1980s and Intern
et stocksin the 1990s, to validate their position that market prices can be affected by the irrational behavior of investor
s.
Behavioral finance is in conflict with the perspective of efficient market theory, which maintains that market prices are
basedon rational foundations, like the fundamental financial health and performance of a company.

What is Behavioral Finance?

One of the terms that tends to pop up more and more when people talk about
money and economics is behavioral finance.
Behavioral finances is a relatively new field of study. The idea is to look at the
reasons that people make the money choices they do (those choices are often
irrational). Behavioral finance applies psychological theories, particular those
related to cognition and behaviorism, to economics and personal finance.
Behavioral finance is all about trying to understand biases in human behavior when it comes to
money. By extension, the personal decisions that people make about money can be extended to
influence the economy. With more and more individuals participating in the economy through
consumerism as well as investing, it is little surprise that what makes humans tick when it
comes to money is of prime interest.

Key Concepts in Behavioral Finance

It helps to understand some of the key concepts in behavioral finance if you want to
grasp what this study is all about. Here are some of the main ideas that stem from
behavioral finance:

Mental Accounting This is the tendency of people to designate money for

a certain purpose. For instance, they divide up money and treat it differently,
depending what account its in. So, money in a savings jar is treated differently
than money meant for debt repayment. People tend to say that money in that
savings jar cant be used for another purpose, even if it means paying down debt

at 15% interest.
Herd Behavior Following the crowd is something quite common, and it
results in some of the most interesting effects. As the larger group does
something like buy a hot stock, or sell in a panic when the market drops
individuals tend to follow suit. Breaking herd mentality is one of the best things
you can do for your own finances.

Anchoring This is the idea that you attach your spending level to a specific
reference. You might think that a good bottle of wine should cost a certain
amount of money. You might see the most expensive wine on a restaurants list
costs $100 a bottle. Normally, you would only spend $25 on a bottle of wine. But
since you are now anchored to the idea of the best costing $100, you dont
want to spend only $25. Instead, you compromise on a $45 bottle of wine.
You spent more than you wanted, because of that anchor. The same thing

happens with clothes, shoes, homes, and a number of other purchases.

Belief in Being Above Average Most people rate their intelligence as
above average. At least thats what my Psychology Ph.D. husband tells me. He
also points out that most people see success as something that they caused.
Setbacks, though, are blamed on external forces. So, an investor might believe
that he or she is a stock picking genius when an investment performs well.
However, when that investment tanks, that same person, rather than believing
that he or she is below average at stock picking, blames the drop on the
market or the economy.

There are other concepts in behavioral finance that help explain irrational human
behavior. You can overcome some of these biases, though, by being aware of them,
and adjusting your own behavior to reflect more practical and rational behaviors.