Prelim Flashcards
the study of how emotions, habits, and thinking patterns affect the way people make financial decisions.
It challenges traditional finance by recognizing that investors often act irrationally due to psychological and emotional biases. It integrates psychology and sociology to explain real-world financial behaviors.
Behavioral Finance
assumes people always act rationally with money.
It is based on the assumption that individuals are rational, always make optimal decisions, and aim to maximize utility.
Traditional financial
Key concepts of Behavioral Finance
- Impulsive spending
- Peer influence and social pressure
- Fear of missing out
- Difficulty saving money
- Overconfidence in financial decisions
- Mental accounting
Buying things without thinking, often because of emotions or advertisements. - Example: Purchasing the latest gadget just because it looks cool, without checking if it’s necessary.
- Why it matters: Impulse buying can lead to financial regret and unnecessary expenses.
Impulsive spending
Making financial decisions based on what others are doing.
- Example: Buying expensive clothes or a new phone just to fit in.
- Why it matters: Following trends without thinking can lead to overspending and financial stress.
Peer influence and social pressure
- Feeling the need to spend money to be part of an experience or trend. - Example: Going to an expensive concert even if you can’t afford it, just because friends are going.
- Why it ma?ers: can lead to unnecessary spending and poor financial choices.
Fear of missing out
Choosing immediate rewards over long-term financial security.
- Example: Spending all your money on entertainment instead of saving for future needs.
- Why it ma?ers: Learning to save early builds financial stability and independence.
Difficulty Saving Money
- Thinking you know more about money than you actually do, leading to risky choices.
- Example: Spending all your earnings assuming you’ll always have more money in the future.
- Why it ma?ers: can lead to poor money management and financial problems later.
Overconfidence in Financial Decisions
Treatng money differently based on where it comes from. - Example: Spending gift money freely but being careful with money earned from a job. - Why it ma?ers: Viewing all money equally helps with be?er budge9ng and saving.
Mental accounting
Decision-Making Errors and Biases
Cognitive Bias
Emotional Bias
These biases arise from faulty reasoning or mental shortcuts (heuristics) that can lead to irrational financial decisions.
Cognitive Biases
These biases stem from emotions rather than logical reasoning and often lead to poor financial decisions.
Emotional Biases
Cognitive Biases
- Overconfidence Bias
- Confirmation Bias
- Anchoring bias
- Representativeness bias
- Hindsight bias
- Mental accounting
Investors overestimate their knowledge, skills, or ability to predict the market.
Example: A trader makes risky bets because they believe they can consistently beat the market.
Overconfidence Bias
People seek out and favor information that supports their existing beliefs while ignoring contradictory evidence. · Example: An investor believes a stock will rise and only reads positive news about it while ignoring warning signs.
Confirmation Bias
Investors rely too heavily on initial information (the “anchor”) when making decisions.
Example: An investor refuses to sell a stock that dropped from P100 to P50 because they are anchored to the original purchase price.
Anchoring bias
People assume that past patterns will continue in the future, often leading to wrong conclusions.
· Example: Seeing a stock rise for five days and assuming it will keep rising indefinitely.
Representativeness bias
Investors believe that past events were predictable, even though they weren’t.
Example: After a stock market crash, people say, “I knew this would happen!”—even though they didn’t act on it before
Hindsight bias
Treating money differently based on its source or intended use. ·
Example: Splurging a lottery win but being frugal with salary income, even though it’s all money.
Mental accounting
Emotional Biases
- Loss aversion
- Herd mentality
- Regret aversion
- Status quo bias
- Self-control bias
People fear losses more than they value equivalent gains (also known as Prospect Theory).
· Example: Holding onto a losing stock because selling it would make the loss “real,” even though it’s better to cut losses.
Loss aversion
Investors follow the crowd, assuming that the majority must be right.
· Example: Buying a stock just because “everyone else is doing it” (leading to bubbles).
Herd mentality
Fear of making the wrong choice leads to inaction or poor decisions. ·
Example: Not investing in the stock market because of fear of losing money, even though long-term investing builds wealth.
Regret aversion
Preferring to do nothing rather than making a change, even when a change would be beneficial. ·
Example: Sticking to a low-interest savings account instead of moving money to higher-yield investments.
Status quo bias
Struggling with short-term temptations over long-term financial goals.
· Example: Spending all your money on luxury items instead of saving for retirement. · Decision-Making Errors and Biases
Self-control bias
How to overcome these biases?
- Awareness
- Diversification
- Long-term thinking
- Data-driven decisions
- Seeking advice
Recognizing biases helps reduce their impact.
Awareness
Avoid putting all money in one stock due to overconfidence.
Diversification
Avoid panic-selling during market downturns.
Long-term thinking
Use logic, not emotions, when making investments.
Data-driven decisions
A financial advisor can provide an unbiased perspective.
Seeking advice
Building blocks of Behavioral Finance
- Heuristics
- Prospect theory
- Market inefficiencies
- Emotional and cognitive Biases
People often rely on rules of thumb or mental shortcuts when making financial decisions, especially in complex situations. While it can be helpful, they often lead to systematic biases.
People use simple rules to make financial decisions, often leading to biases.
Heuristics
Developed by Daniel Kahneman and Amos Tversky, this theory states that people feel losses more intensely than equivalent gains (loss aversion). This leads to irrational decision-making.
Prospect theory
Traditional finance assumes markets are efficient, but behavioral finance argues that investor psychology leads to inefficiencies such as bubbles, crashes, and anomalies.
Psychological biases cause financial markets to behave irrationally.
Market inefficiencies
Investor decisions are influenced by emotions and cognitive errors, leading to deviations from rationality.
Emotional and cognitive Biases
Making decisions based on easily available information (e.g., overestimating the risk of stock crashes due to recent news).
Availability bias
Investors take more risks to avoid losses than to achieve gains.
Risk asymmetry
The way a decision is presented affects choices (e.g., people prefer a “90% chance of success” over a “10% chance of failure” even though they are the same).
Framing effect
Investors either panic (selling too much) or get overconfident (buying too much).
Overreaction and Underreaction
It happens when the price of something (like a stock, cryptocurrency, or real estate) gets way too high because people keep buying, even though it’s not really worth that much. Eventually, it pops, and prices crash
Bubbles and crashes
