5.3.2.4 Behavioral Finance
Recall that the efficient market hypothesis posits that markets are efficient, and that prices reflect all available information about the securities. Underlying the efficient market hypothesis is the assumption that investors are rational and make investment choices based on investing goals. The new field of behavioral finance argues that investors are not always rational in their investing. Instead, behavioral finance shows that people are influenced by psychological biases that affect their investment decisions. And because investors do not always act in a rational way, and markets are driven by investors, markets do not always behave in a way that traditional economics would predict. As an investment adviser, it is important to understand the psychological biases that may influence how clients may wish to invest their money, how these biases may affect you as a money manager, and how these biases may influence the markets as a whole. Some common psychological influences on investing decisions include the following:
Aversion to loss – Research has shown that many people fear losses more than they desire gains. To demonstrate this, consider the following thought experiment by one of the founding fathers of behavioral finance, Daniel Kahneman. Would you take the following bet? A coin is flipped and if it comes up heads, you receive $2,000, but if it comes out tails you have to pay $1,000. Most of us would not accept this bet, even though the potential gain is higher than the potential loss. Kahneman and Tversky have argued that the pain in losing a sum of money appears to be greater than the pleas