Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes. 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. Put simply, it is the study of human behavior, practice, and tendencies related to finance, economics, and investment decision-making.
The three prevalent themes in behavioral finance are:
– Heuristics: Humans make 95% of their decisions using mental shortcuts or rules of thumb.
– 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 mispricings and non-rational decision making.
Behavioral funds are a category of mutual funds that use behavioral finance as a basis for their investment strategy. Managers of these funds, which are based on a relatively new approach, believe that human behavior leads to certain market inefficiencies that they can take advantage of to get a superior return. Behavioral funds are seeing increased interest among investors and academics given that their underlying principle opens up significant research and analysis opportunities, which allows for a wide variety of investment strategies to be employed in fund creation.
Behavioral Funds: How They Operate
The investment strategies of behavioral funds may pursue the following themes:
– Finding irrational biases in the market, which may exaggerate the impact of negative news-beating the stock prices to much deeper levels (for low-cost buying opportunities), or overplay the impact of positive news by pumping the stock prices to higher levels (for high-cost short selling opportunities).
– Identifying stocks temporarily having lower/higher than expected indicators (like price-to-earnings ratio). Comparing these against other fundamentals, like a company’s credit risk and valuations, may indicate better investment picks in a timely manner.
– Investing in stocks that may have temporarily underperformed relative to the overall market based on irrational exuberance, but continue to have strong fundamentals
– Identify stocks based on other potential developments leading to profitable opportunities, like from an expected share buy-back or stock split.
Behavioral Funds and Investors
It operates under the assumption that different people act differently with their money. As such, behavioral funds seek to take advantage of pricing anomalies that may exist in the continuum between rational investors and irrational investors by tracking their sentiment and decision-making. During periods of market downturn, for instance, investors tend to have a herd mentality of shying away even from investments that are fundamentally sound, driving down their prices. These investors are driven more by their human emotions than by investment fundamentals.
For instance, during the U.S stock market downturn of 2007 through 2009, many emotion-influenced investors fled the stock market leading to bargain buys for savvier investors. The strategy of behavioral funds is to make use of such opportunities to buy stocks, and other investments that other investors avoid, at a discounted price. However, it is not clear whether behavioral funds using such strategies have actually outperformed the market.
Behavioral economics, along with the related sub-field behavioral finance, studies the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and resource allocation, although not always that narrowly, but also more generally, of the impact of different kinds of behavior, in different environments of varying experimental values.
Risk tolerance is a crucial factor in personal financial decision making. Risk tolerance is defined as individuals’ willingness to engage in a financial activity whose outcome is uncertain.
Behavioral economics is primarily concerned with the bounds 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. The study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice.
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