Definition

Behavioral finance studies how people make decisions and examines the psychological factors that influence and skew their decision-making process.

The traditional economic and financial theory generally assumes that market participants always act rationally by considering all available information in the decision-making process. In reality, financial decision-making is a complex situation. When faced with so much information to constantly process and update, people often don’t have the time or ability to come up with a completely optimal decision. Instead, they often take an easier and more subjective approach. They often use only parts of the available information and determine a course of action that best suits their judgment and priorities. They are content with making a “sufficiently good” choice rather than making an “optimal” choice. In this way, they may inadvertently bias the investment decision-making process. 

Behavioral finance does not assume people are always rational. It believes that people are limited in controlling themselves and are influenced by their own biases. These biases are in two main groups: cognitive errors and emotional biases.

Cognitive Errors

These types of errors are basic statistical errors, information processing errors, or memory capacities. They cause decisions to deviate from rationality. In general, cognitive errors stem from faulty reasoning. It can often be, however, mitigated or eliminated through better information, education, and advice. Cognitive errors can be grouped into 2 types:

• Belief perseverance biases: come from the result of mental discomfort. It occurs when new information conflicts with pre existing beliefs or perceptions. To resolve this dissonance, people are likely to ignore conflicting information. They only consider information that confirms their existing beliefs and thoughts.

• Information processing biases: refer to information being processed and used in illogical and irrational manners.

Below are some common belief perseverance biases and their corresponding behaviors in financial investment.

Below are some common processing errors and their corresponding behaviors in financial investment.

Emotional Bias

Emotional bias arises spontaneously from feelings and attitudes. It can cause decisions to deviate from rationality. It is typically harder to correct compared to cognitive errors because they originate from impulses and intuition rather than logical calculations. A person usually can only recognize and learn to adapt to it rather than correct itself.

Below are some common emotional biases and their corresponding behaviors in financial investment.

Applications of Behavioral Finance in Algorithmic Hypothesis Formation

The focus of behavioral finance is the study of behavioral biases that influence individual investor decisions. Behavioral finance doesn’t show how to properly predict the future. Nor does it provide a financial investment model that can confidently beat a market. However, behavioral finance still helps investors have a deeper insight into how the market actually works. It helps build more reasonable algorithmic hypotheses.

Price momentum is a common phenomenon in the stock market. It’s an unusual movement of the stock price. It can be observed that when a stock rises or falls sharply in the short term, the trend tends to continue.

In terms of behavioral finance, price momentum can be explained by availability bias – the tendency to forecast an outcome or the importance of a phenomenon based on how easily the information is recollected.

When a stock price keeps rising, investors easily remember this event and unconsciously assume a future rise is more likely than a fall. Besides, hindsight bias causes illusions to investors who believe they could have forecasted a future rise and would regret it when missing the buying opportunity. Investors are thus urged to overcome this regret by placing buy orders even when the stock’s market price is already much higher than its intrinsic value.

Believing the biases above can have a strong market impact, algorithmic traders can take advantage of the price momentum strategy to seek short-term profits.

Behavior finance also explains the phenomenon of absurdly sharp rises in stock prices during a brief period of time. In addition to the price momentum insight above, buying and selling shortly after will still be profitable even if investors have sold too early. A few short-term profits bring a sense of pride and confirm the investors’ belief that they made the right investment.

Hindsight bias can reinforce an investor’s belief that their previous trading strategy was correct and will continue to be profitable in the future. Overconfidence bias gives an illusion of their forecast ability. Conservatism bias makes investors ignore contradicting information or opinions. As a result, investors are still willing to open more long positions at high prices, even using margin to increase purchase power. It further causes increased demand and the stock price continues to rise rapidly.

Yet in the context of absurdly rising stock prices, investors can apply the mean-reversion strategy. They can open short positions when the security price already rises too quickly and expect it will revert back to the reasonable mean.