Behavioral finance studies the effect of psychological factors on human behavior, which further affects asset price movements. Standard financial models assume that individuals are rational and risk-averse. In reality, individuals may be however irrational and risk-seeking. Investors could be risk-averse or risk-seeking. Behavioral finance models do not adhere to the traditional assumptions of rationality and risk aversion but investigate how irrationality and behavioral bias affect our decisions. Basic behavioral finance concepts are briefly summarized below (Hon et al., 2021).

The Prospect Theory

Tversky and Kahneman (1981) consider that individuals could be judged irrational either because their preferences are contradictory or because their desires and aversions do not reflect their pleasures and pains. Prospect theory developed by Kahneman and Tversky (1979) is used to explain irrational behavior under risk and uncertainty due to cognitive bias. The theory tries to model real-life choices among risky prospects that are inconsistent with the basic tenets of expected utility theory rather than an optimal decision. The prospect theory begins with the value function from which people react differently when faced with potential gains and losses. The value function is concave for gains, convex for losses, and is generally steeper for losses than for gains indicating that losses outweigh gains. Under the prospect theory, people make decisions based on potential gains or losses relative to their reference point rather than absolute wealth values. Wong and Chan (2008) and others link the prospect theory with the theory of stochastic dominance while Bai, Li, Liu, and Wong (2011) develop corresponding statistics with applications.

Mental accounting

Mental accounting (or psychological accounting) refers to the different values people place on money based on subjective criteria, leading people to make irrational decisions. When framing refers to how a problem is posed for decision-makers, one important feature of mental accounting is narrow framing, which treats individual gambles separately from other portions of wealth. Then, people tend to separate decisions that should be combined according to the principle of rationality. Gains and losses are treated separately so that, as predicted by the prospect theory, people are risk-averse when they gain but risk-seeking when they experience loss. There are many applications of mental accounting, see, for example, Egozcue and Wong (2010) and Egozcue, Massoni, Wong, and Zitikis (2014).

If information about the best course of action under 7uncertainty arrives after taking a fixed decision, the negative human emotion of regret is often experienced. Regret is the pain that people feel when they consider themselves better off if they had not taken a certain action in the past. The value of regret can be measured as the difference between a made decision and the optimal one. The theory of regret proposes that when facing a decision in an uncertain environment, regret-averse individuals incorporate the possibility of regret in their decision-making process to avoid its occurrence. Regret aversion can be used to explain many economic theories, for example, the optimal output of a competitive firm (Egozcue, Guo, and Wong 2015).

Disposition effect

The disposition effect considers that investors dislike incurring losses more than they like making profits, and they are eager to gamble on losses. As a result, investors will tend to sell assets that have risen in value but keep assets whose prices have declined. In other words, they sell winners too early and keep losers too long. The cause of the disposition effect can be explained by the prospect theory mentioned above, which shows that investors are risk-averse when they earn profits but are risk-seeking when incurring losses. Hence, risk-seeking investors tend to keep the losing investments to later bet on the possible rebound in the face of loss. They also want to avoid the feeling of regret when they realize a loss from making a wrong investment decision previously or when the price rebound occurs after the sale of losing investments.

Cognitive dissonance is the perception of the contradictory information and relevant information items including people’s actions, feelings, ideas, beliefs, values, and things in the environment. Hence, cognitive dissonance is a mental conflict that people experience when presented with evidence that their beliefs, values, or assumptions are wrong. Cognitive dissonance is then classified as the pain of regret over erroneous beliefs. The theory of cognitive dissonance asserts that people tend to reduce cognitive dissonance. For instance, they may avoid new information or develop contorted arguments to maintain their beliefs or assumptions. Also, investors avoid negative information about a stock they purchased and focus on its positive news only.

Disappointment theory

Disappointment as a source of psychological stress refers to the feeling of dissatisfaction associated with the failure of hope. It is observed that people considering risks when making decisions are disappointed when the outcome of the risk is not evaluated as positively as the expected outcome. The disappointment theory states that individuals will become disappointed discovering that the outcome is worse than they expected, and they will be elated if the outcome is better larger than they expected. People are then averse to disappointment. The theory of disappointment explains why disappointment-averse people are more likely to choose a certain reward than to risk a greater reward while at the same moment, they are eager to choose a greater reward with a lower probability when both choices include some risk. There are many applications of disappointment theory, see, for example, Guo, Egozcue, and Wong (2021).

Availability heuristic

The availability heuristic (or availability bias) is a mental shortcut that relies on immediate information to a given person’s mind when assessing a specific topic, concept, method, or decision. Hence, if something or some memory can be recalled, people would think that it must be important, or at least more important than others that are not as readily recalled. The availability heuristic operates when limited attention, memory and processing capacities focus only on subsets of available information. Unconscious associations also create focus. Selective triggering of association causes salience and availability effects. An information signal is salient if it has special characteristics that are good at grabbing hold of our attention or at creating associations that facilitate recall. In the availability heuristic, items or events that are easier to recall are more common. Under the availability heuristic, investors tend to heavily weigh their judgments toward more recent information about a stock’s prospects, and investment decisions are made irrationally toward that latest news.

Representative heuristic

The representative heuristic involves estimating the likelihood of an event in the face of uncertainty, which depends on the degree to which the evidence is perceived to be similar to or typical of the state of the world. People’s perceptions of how “representative” a piece of evidence is of a state of the world may be inaccurately related to its conditional probability. People, for example, tend to rely too heavily on small samples and too little on large samples, inadequate discount for the regression phenomenon and selection bias in the generation or reporting of evidence. Under the representative heuristic, people usually make biased judgments because something more representative does not make it more likely. Companies with very low P/E ratios, for example, are thought to be temporarily “undervalued” because investors become overly pessimistic after a string of bad earnings reports or other bad news. The price will adjust if future earnings prove better than the overly pessimistic forecasts. Lam, Liu, and Wong (2010, 2012) and Guo, McAleer, Wong, and Zhu (2017) use the idea of representative heuristic to develop the theory that can be used to explain several financial anomalies, including short-run underreaction, long-run overreaction, magnitude effect, and excess volatility while Fabozzi, Fung, Lam, and Wong (2013) have developed 3 different tests to test for short-term underreaction, long-term overreaction, and others.

Anchoring and adjustment

The anchoring effect is a cognitive bias whereby a particular reference point or anchor influences an individual’s decisions. In many situations, once an anchor is set, people will adjust away from it to get to their final solution. However, they adjust insufficiently, and the final guess becomes closer to the anchor than otherwise. In other words, different anchors yield different estimates, which are biased toward the anchors. We call this phenomenon anchoring-and-adjusting, under which investors initially have in their minds some reference points or anchors, such as previous stock prices or the most recently remembered prices, but then they adjust this past their reference points insufficiently due to underreaction to new information acquired. Anchoring describes how individuals tend to focus on recent behavior and give less weight to longer-time trends.

Ambiguity aversion

Ambiguity aversion (or uncertainty aversion) refers to a preference for known risks over unknown risks. An ambiguity-averse individual would prefer a choice where the probability distribution is known rather than one with an ambiguous probability distribution. In financial markets, investors are usually uncertain about the probability distribution of an asset’s return. The ambiguity-averse investor holds a range of possible probability distributions in mind and maximizes the minimum expected utility under any possible distribution. The investor has a reference probability distribution in mind but wants to ensure that his decisions are good ones even if the reference model is misspecified to some extent. Also, if the investor feels concerned that his model of stock returns is misspecified, he will charge a substantially higher equity premium as compensation for the perceived ambiguity in the probability distribution.

Overconfidence

Overconfidence is a behavioral bias in which an individual’s subjective confidence in his judgments is reliably larger than the factual accuracy of those judgments, especially when confidence is relatively high. Overconfidence implies over-optimism about the individual’s ability to succeed in his endeavors. When the investor takes too much credit for his successes, it leads him to be overconfident. Overconfidence may not make the investors wealthier, but the process of accumulating wealth can make investors overconfident. Overconfidence is caused by investors’ success so that the overconfident investors can survive in the market. Overconfident investors are predicted to trade excessively, resulting in large trading volumes and market volatility. Excessive trading behavior may however reduce the net returns in the market. Lam, Liu, and Wong (2010, 2012) and Guo, McAleer, Wong, and Zhu (2017) develop a theory that can be used to explain several financial anomalies, including overconfidence. Readers may refer to Lu, Wang, and Wong (2022) for more information on trading strategies with overconfidence.

Time preference and self-control

The conventional representation of decision-making over time is usually modelled by an additively separable utility function with exogenous, declining exponential weights. However, evidence from psychological research proposes that discount rates are dependent upon a range of psychological variables such as consideration of future consequences, conscientiousness, extraversion, experiential avoidance, and self-control. For example, deferring consumption involves consumer self-control and is linked to mood and emotional states. It is found that discount rates are sometimes bizarrely high, that gains are discounted more heavily than losses, that small magnitudes are discounted more heavily than large magnitudes, that the framing of choice as a delay versus an advance has a large effect on decisions, that time preference differs greatly in different judgment domains (e.g., money versus health). Readers may refer to Lu, Yang, and Wong (2018) and Lu, Hoang, and Wong (2021) for more information on trading strategies with time preference.

Herd effect

Herd behavior in social psychology refers to the behavior of individuals in a group acting collectively without centralized direction but could also be caused by correlated prevailing information in independently acting individuals. Hence, people will do what others are doing rather than optimal given their information. As a result, behavior patterns are correlated across individuals. Herding also describes a situation in which investors abandon their beliefs but adopt “moving with the market” or “following the general market trend” to earn excess returns. As a direct consequence, herd behavior leads to the development of trading strategies in financial markets, such as the momentum investment strategy, to outperform the market. Readers may refer to Batmunkh, Choijil, Vieito, Espinosa-Méndez, and Wong (2020) and others for more information on trading strategies by using the herding effect.

Ostrich effect

The ostrich effect which is a cognitive bias refers to the investors’ behaviors to avoid negative financial information that brings psychological discomfort. The ostrich effect predicts that investors collect additional information conditional on favorable news and avoid information following bad news.

Endowment effect

The endowment effect (or divestiture aversion) refers to a situation in that people have a perception of a higher value on an object that they already own than the value they would place on that same object without owning it (Ganti, 2021). Under the endowment effect, an investor tends to keep unprofitable assets he owns because their current market values are lower than his perception of their values. Moreover, a person who inherits an estate may not be eager to divest it, even if the estate does not match his asset allocation strategies, because his perception of its value is larger than its market value.

References

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