Knowledge & Podcast

Being human in an (ir)rational market: the role of behavioral finance

by Marianna Randazzo, Junior Training Specialist of Excellence Education

In 1999, an Economist article entitled “Rethinking thinking” opened with the following question: “Are economists human?” “Are economists human beings?” and investigated the role of emotions within investment dynamics through so-called behavioral finance[1]. But what is meant by “behavioral” finance?
Behavioral Finance and Prospect Theory

Behavioral finance is a branch of financial economics that began to emerge between the late 1970s and 1980s, when cognitive psychologists Daniel Kahneman and Amos Tversky began to question the foundations of traditional economic theories. Until then, it was believed that man entrusted his choices only to logical deductions and moral principles, completely ignoring emotions. According to the two scholars, however, emotions and non-rational factors have significant effects on investment choices. Through cognitive psychology techniques, they explained that there are a whole series of anomalies in the rational economic decision-making process and how individuals actually behave when faced with a decision: it is Prospect Theory, the prospect theory, which, through empirical evidence , deals with the decisions of individuals in risk situations and how these can change as certain conditions change.

There are two main conclusions of Prospect Theory:

  1. Individuals evaluate decisions in terms of gains and losses and not in terms of overall wealth: we focus only on a certain option that affects financial results instead of evaluating the overall financial situation;
  2. Individuals assign different decision weights depending on the circumstances. When it comes to a profit situation, people demonstrate an aversion to loss rather than a propensity to pursue the gain itself. On the contrary, in situations of loss, a “reflection effect” occurs in which individuals tend to focus mainly on the final situation of wealth, ignoring the initial loss[2]. Casino slot machines can be a good example: the player does not give importance to small and frequent losses in favor of the expected win. However, the sum of the small losses is often greater than the few wins obtained.

Kanheman and Tversky’s Prospect Theory leads us towards a further aspect of behavioral finance that can actually be adapted to any area of each of us’s daily lives: cognitive biases.
Cognitive biases are nothing more than errors in judgment, behavioral distortions that automatically lead the individual towards wrong choices. It is an induced behavior, a sort of predisposition to error that everyone, or almost everyone, experiences daily in their lives[3]. There are numerous types of bias that explain the irrational behavior of human beings very well and which are well expressed in the economic and financial field, proving that, in fact, economists are human beings. Let’s see some of them.

Overconfidence bias
It is the tendency of human beings to overestimate their abilities and capabilities and not to consider all potential risks. Very often we don’t realize it, but it happens to everyone to find themselves in the trap of overconfidence, whether it’s a work context or not.

Anchoring bias
It is the tendency to rely on the first explanation given to us. Whether it is an investment or the choice of what to eat for dinner, the human brain interprets the most recent information as correct (it “anchors”), averting its gaze from an objective vision, sometimes leading to errors.

The herd effect bias
It is that bias that occurs when we trust the judgment of the majority, stopping to consider our own. We try to conform our ideas to those of others, thinking that the group, the mass, is always right.

Behavioral finance applied to a real case: the 2007-08 financial crisis
Let’s go back to the initial question posed by the Economist in 1999: “Are economists human?”. The definitive answer is given by a now emblematic “case study” which however has marked the lives of many people in the last twenty years: the financial crisis of 2007-08.

We will not dwell on the story of the crisis from a financial point of view, but we will try to demonstrate the fact that what happened in those years can also have a behavioral explanation. The Prospect Theory seen above explains it well: in times of crisis we tend to abandon the rational approach in favor of a more emotional and empathetic one.

In fact, when investing, people are guided by feelings of ambition or fear. Those with ambition, driven by the illusion of easy money, will continue to take ever greater risks; those who are afraid, seeing their shares collapse for a prolonged period, will begin to sell causing a further collapse in prices. Both behaviors thus become the main driving factors of financial crises. All the examples of bias described here can easily be found in the financial crisis:

  • Overconfidence: the excessive confidence shown by investors and analysts led to an incorrect assessment of market risk which did not take into account the imbalances and vulnerabilities that were already on the surface.
  • Anchoring: the first information we are given is not always the correct one and this also happened during the financial crisis. The banks trusted the rating on the structured securities collateralized by mortgages, initially classified as AAA (the maximum score) by the main rating companies. The securities, as we all know, turned out to be junk.
  • Herd effect: many people ignored the risk of depreciation in the value of the houses that served as collateral for the mortgage, because that’s what everyone did; investment banks, for their part, filled their balance sheets with securitized mortgages, because that’s what everyone else did. In both cases, the collapse in house prices and securitized securities caused the bubble to burst, causing mortgages to default and bank assets to become waste paper.

The financial crisis of 2007-08 is a painful chapter in economic history that tangibly demonstrated the relevance of behavioral finance. Beyond the numbers and graphs, the crisis was shaped by human emotions, fueled by ambition and fear, the drivers of financial decisions. In this scenario, the theories developed by Kahneman and Tversky have provided an illuminating framework.
Through the study of behavioral finance and the analysis of cognitive biases, more robust investment strategies can be developed in the face of the complexity of human emotions in the financial scenario.

[1] The Economist, 1999

[2] Kahneman, D., Tversky, A., Prospect Theory: An Analysis of Decision under Risk, Econometrica, 1979, 47(2), 263–291.

[3] Cervellati, E. M., Finanza comportamentale e investimenti – Oltre l’approccio tradizionale per comprendere gli investitori, Milano, McGraw-Hill, 2012.


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