Behavioral Finance Theory and Value Investing

Are you as rational as you think?

Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies.

It includes investor behavior that can't be explained by traditional finance theory.

It is assumed that the information structure and the characteristics of market participants systematically influence individuals' value investing decisions as well as market outcomes.

What Insights Does Behavioral Finance Offer?

It attempts to explain why investor behavior is not perfectly rational as assumed by the efficient market hypothesis which has been shown to contain a number of contradictions.

Greed, fear, expectations and circumstances are all factors that contribute to investors' overall investing mentality or sentiment.

Behaviorists explain that, rather than being anomalies, irrational behavior is commonplace.

Examples of Irrational Behaviors

Some examples of this irrational behavior follow. Do they apply to you? ...

  • Investors tend to give priority to avoiding losses. They often hold onto loss-making stocks, believing that the price will eventually come back.
  • After buying a losing stock, and faced with the prospect of having to sell it, investors become emotionally affected by the price they paid for it.

    They experience the regret of buying a losing stock and further regret of not selling it when it becomes obvious that a poor investment decision was made.

  • When a market is moving up or down, investors become fearful that others are more knowledgeable and as a consequence, tend to follow a herd instinct and do what others are doing.
  • Investors hesitate to sell an investment that once had large gains and now has a modest gain.
  • Behavior finance has also found that investors tend to place too much emphasis on judgments derived from small samples of data or from single sources.
  • Investors are known to attribute skill rather than luck to an analyst that picks a winning stock.
  • Investors express a different degree of emotion towards gains than towards losses. They are more stressed by prospective losses than they are happy from equal gains.
  • Because investors are optimistic when markets go up and very pessimistic when they go down, prices fall too much on bad news and rise too much on good news.
  • Too much emphasis is placed by investors on recent news or views. Recent prices are given more credence than historical ones.

    This explains why, on a market downturn it is common for investors to find it difficult to believe that prices could fall so far. They had put 'price anchors' in place which unfortunately slipped. Is this familiar to you?


To Conclude

While behavioral finance helps to highlight our irrationalities and explain why markets have behaved the way they have in the past, it does not have any predictive value.

Instead it tells us why investment psychology causes stock intrinsic values and stock prices to diverge over long periods.

These divergences between stock price and intrinsic value provide value investing opportunities; buying opportunities when stock prices drop below the intrinsic value of stocks, and selling opportunities when prices soar above.

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