Intro To Behavioral Finance

Behavioral finance examines the influence of psychological factors on the decision-making processes of investors and financial markets. The study is primarily concerned with explaining the reasons behind the frequently observed phenomenon wherein investors exhibit an absence of self-control, engage in actions that are in contrast to their optimal outcomes, and base their decisions on personal biases rather than objective facts.

Amos Tversky and Daniel Kahneman’s first paper on biases

The field of behavioral finance originated in the 1970s when Daniel Kahneman and Amos Tversky researched individuals’ decision-making processes when faced with choices that involve varying degrees of risk. It was discovered that individuals tend to consider the potential value of losses and gains rather than making rational decisions based solely on objective outcomes. Additionally, it was found that the assessment of these gains and losses is accomplished through the utilization of heuristics, which are cognitive shortcuts or informed guesses used for rapid problem-solving relying on our prior experiences.

Thinking Mode

Decision making can be broken down  with System 1 and System 2 thinking. 

  • System 1 thinking refers to the rapid, involuntary, subconscious, and affective cognitive processes that our brain engages in when responding to various situations and stimuli. This may appear as the act of
  •  unconsciously reading an ad on a billboard or the ability to effortlessly tie your shoe.
  • System 2 thinking refers to the cognitive process that involves slow intentional, and logical processes that our brains engage in when tackling complex problem-solving tasks. Some examples are attempting to locate a friend in a crowded area, or carefully parking your car in a tight area.

Test Your Thinking

There is a patch of lily pads on a lake.  Every day the patch doubles in size.  If it takes 48 days for the lily pads to cover the entire lake, how long will it take for the patch to cover half the lake?

47 Days

Did you answer something else?  Don't feel bad if you did.  Most people answer 24 days, which is System 1 thinking at work.  Most peoples' impulse is to divide 48 days in half since we're thinking about half the lake being covered.  The question requires System 2 thinking, because the lily pad growth is exponential and not linear. 

No Gain, Less Pain?

Kahneman and Tversky’s research findings indicate that individuals’ decision-making processes are influenced by a dominant tendency to avoid losses when using heuristics. Additionally, it has been demonstrated that individuals experience more than twice the pain in response to losses compared to the level of pleasure they derive from gains.

Due to their practical and economical nature, heuristics are regarded by some as facilitators of accurate and thus improved decision-making. Nevertheless, a significant amount of research indicates that these “shortcuts” are often associated with biases, which in turn contribute to errors in judgment and sub-optimal investment results.

Types of Biases?

One widespread heuristic involves the assumption that future returns can be predicted based on past returns. While this perspective may appear reasonable at first glance, it fails to consider the dynamic nature of the economy and the extent to which a stock may already be priced at its fair value.

For example, an investor may make the conclusion that due to the consistent positive returns of an emerging markets equity mutual fund over the previous five-year period, it would be prudent to either maintain or potentially increase their investment in the mutual fund. However, it is possible that the mutual fund has experienced a change in leadership, or there has been a shift in the overall market that has not been seen in the last 5 years. Using psychological heuristics in the investment analysis process may negatively impact a portfolio.

So, what exactly are these biases:


The hindsight bias refers to our tendency to retrospectively see an unexpected event as having been easily predicted.

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Loss Aversion

Loss aversion is a cognitive bias that explains why individuals tend to experience the psychological impact of losing something as...

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Overestimate our intellect and skill can result in underestimating risks and overestimating potential gains.

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