Introduction to Behavioral Finance | CFA Level I Equity Investments

Today, we’ll be diving into the fascinating world of behavioral finance, an area that challenges traditional finance’s assumptions about rational decision-making in the market. Let’s start by comparing traditional and behavioral finance.

Traditional Finance vs. Behavioral Finance

In traditional finance, investors are thought to consider all available information and make rational decisions by maximizing utility within budget constraints. This leads to the belief that market prices are rational and support the idea of efficient markets.

On the other hand, behavioral finance doesn’t make these assumptions about investors. Instead, it acknowledges that investors can be selective with information and may not always make rational decisions. Research has shown that individual investors can be inherently irrational, exhibiting biases and failing to evaluate risk as traditional models predict.

Market Efficiency and Investor Rationality

So, are markets efficient or not? It depends on how you define market efficiency:

• If investor rationality is a prerequisite for market efficiency, then markets are not efficient.
• If market efficiency only requires that investors cannot consistently earn abnormal profits, then markets can still be considered efficient, even with irrational investors. This is because other investors observing irrational behavior will respond accordingly, keeping prices in line with intrinsic values and eliminating abnormal profits.

Examples of Irrational Investor Behaviors

Now, let’s take a look at some common investor behaviors and biases that are considered evidence of irrationality:

Loss Aversion

Loss aversion is when investors feel more pain from losing money than joy from gaining an equal amount. This is different from risk aversion in traditional finance, which is rational behavior. Loss aversion is considered irrational because the dissatisfaction from a loss shouldn’t outweigh the satisfaction from an equal gain.

Overconfidence

Overconfidence is when investors overestimate their ability to process and interpret information about a security. This can lead to temporary mispricing, but most researchers argue that prices will eventually correct themselves.

Herding

Herding is when investors act in concert on the same side of the market, often mimicking the investment actions of others rather than acting on private analysis. This can explain underreaction and overreaction in financial markets.

Information Cascades

Information cascades are similar to herding, but investors don’t follow blindly. Instead, they make decisions influenced by the information from other investors. Some argue that this can actually support market efficiency if more knowledgeable investors act first and others follow, moving prices toward their intrinsic values.

Wrapping Up

As you can see, behavioral finance provides both arguments for and against market efficiency. We’ve only just scratched the surface, as this topic will be discussed in more detail under Portfolio Management.