Originally this blog was written in 2010, I’ve modified and reposting it due to recent conditions in Financial Markets
Behavioral Finance is a sub field of Behavioral Economics that mainly deals with human psychology as it pertains to Investment decisions. Here in this blog my attempt is to bring educational awareness and understanding regarding this topic and to explain why it matters in investment decisions.
Per Investopedia, the definition of Behavioral Finance, “Psychological influences and biases affect the financial behavior of Investors and financial practitioners”. In simple terms, it’s a study of human emotions and how it impacts an individual in making his investment decisions. Therefore, at the height of panic or fear in the financial markets, an average investor may sell his investments at a significant loss just because everyone else is selling, his fear overcomes his rationality of making prudent financial decision. This behavior was observed during the market bottom in March 2009/2020. Similar but opposite situation would be that of at the height of exuberance or over confidence; an investor may buy an asset just because everyone else is buying, and in this case his overconfidence overcomes his rationality of making prudent financial decision, for example, buying and flipping houses during the Real Estate bubble of 2008 or buying meme stocks in 2021. Investors make bad financial decisions when they are in an emotional state and follow herd mentality.
Herd mentality is the psychology of an investor to make decisions with limited information and follow other investors just because it’s a trend or fad. It’s an event of hearing exuberant stories of typically high risk and high rewards of others and then attempting to replicate it by taking the same high risk in order not to miss out on the opportunity. Recent example is the investment in meme stocks, such as GameStop Corp. where Reddit traders and investors piled up to elevate the stock price to unprecedented levels with few knowing how terrible were the fundamentals of the company which was on the verge of bankruptcy. Another recent example is that of Bitcoin and crypto currencies, where retail investors along with sophisticated Wall Street gurus got on the bandwagon of elevating the Crypto currencies prices without much understanding of the fundamentals, this was all not to miss out on the opportunity and delusions of making a fortune, shows sometimes even the sophisticated professional money managers are not immune to the herd mentality.
The final part of this blog is about stories, in their book “Animal Spirits”; authors George Akerlof and Robert Shiller state that “the confidence of a nation, or any large group, tend to revolve around stories. They further quote Roger Schank and Robert Abelson, that storytelling is fundamental to human knowledge. For People, memories of essential facts are indexed in the brain around human stories. It’s observed that when people do well financially, they tend to get excited by telling their stories of good fortune, which impacts others to follow similar path and attempt to gain success and make their own stories and that in turn spreads on as new stories. I’ll also mention a story that I read some time ago, about a group of people taking shuttle service to a Las Vegas casino, where on the shuttle the people were told phenomenal success stories of making fortunes in the casino through gambling but no one talked about the phenomenal losses incurred in the casino. Similarly, in extreme panic or fear mode, people tend to forgo opportunities as the pain from losses is too great, this is observed right when the pessimism in market is high and investors get overly cautious.
Most of the financial bubbles are formed due to overconfidence, herd mentality and following exuberant success stories of others. There is saying by a legendry investor John Templeton, “Bull markets are born on Pessimism, grown on skepticism, mature on optimism and die on euphoria”.
Here are some books that I recommend to read on this subject.
Animal Spirits by George Akerlof and Robert Shiller
Fooled by Randomness by Nasim Taleb