The principles of behavioral finance focus on the pain of loss aversion. Nobel Prize winner Daniel Kahnemann found that we feel the pain of loss about 2.25 times more than the pain of gain. Therefore, to feel as though we are making a gain on a $1 investment, we would have to see a $2.25 gain first. Behavioral finance is the study of how people make financial decisions, and how to reduce or eliminate biases in their decisions.
Behavioral finance is based on research and experiments that reveal human limitations, including the difficulty of overcoming flawed ideas. In short, behavioral finance aims to explain anomalies in the financial markets, and proposes psychological-based explanations to explain them. The underlying principles of behavioral finance are a combination of cognitive psychology, human nature, and limits to arbitrage. As a result, the study of behavioral finance provides us with new insights into our behavior in financial markets.
Traditional economic and financial theory assumes that humans are rational, and that they make rational decisions, update their beliefs as new information becomes available, and make normatively-acceptable decisions. However, in reality, humans act irrationally. As a result, as much as eighty percent of individual investors and thirty percent of institutional investors behave irrationally. Behavioral finance focuses on the cognitive aspects of investing and draws from psychology, sociology, and biology.
John Keynes was a British economist who first put forward the theory of behavioral finance in 1936. Keynes noted that the market behaves like a beauty contest, where judges choose a winner based on what their peers expect. In a similar way, investors act in a consensus manner and combine their expectations. By understanding our biases, we can make better decisions in the financial markets. If we understand our biases and can overcome them, we can earn higher returns.
Prospect theory, which is often considered the father of behavioral finance, replaces expected utility theory. It is a modern-day version of the expected utility theory. Prospect theory consists of four major components, including reference points, probability weighting, loss aversion, and diminishing sensitivity. These principles have been the backbone of behavioral finance for over 20 years. So what can we learn from behavioral finance? The answer is simple: human behavior and our emotions play an important role in our financial decisions.
As a financial adviser, it’s important to ask your clients about risks and returns. Today’s bull market is entering its 10th year, and interest rates in the developed economies are on the rise. Behavioral finance is an invaluable tool for financial advisors. In addition to risk and returns, it helps build a relationship between the adviser and the client. If you want to know more about the behavior of your clients, ask them a series of questions about their risk tolerance, behavioral biases, and more.