The efficient market hypothesis asserts that in a highly liquid market, stock price values efficiently reflect all available information. If only markets, and life, were so easy. Individual investors do not always view the value of their investments based solely on current and future intrinsic and external factors. Especially in the short term, people’s cognitive limitations, psychological factors and thinking biases often influence their decisions, individually and as a group.
Financial planning professionals need to understand more than the numbers and the math behind budgets to provide optimum benefits to their clients. To help their clients make prudent decisions, financial planners also need to understand the motivations, behaviors and psychology of individuals when it comes to money. Incorporating this understanding in financial planning is critical to deepening client relationships and improving investor outcomes.
The Master of Science in Finance online program from the University of Illinois Springfield equips graduates with the financial and economic knowledge to work in the field and a thorough understanding of behavioral finance to better understand humans who propel the investing market.
What Is Behavioral Finance?
Behavioral finance is a behavioral economics theory that asserts that individual biases and psychological factors strongly affect financial decision-making. The study of behavioral finance examines the intersection of human psychology, sociology, culture and economics to provide insights into how and why people make financial decisions and how these influences affect markets. It explores how emotions and biases lead to sub-optimal individual investing behaviors and how they manifest in larger investor group behavioral dynamics like overconfidence, speculation, market volatility, bubbles and even crashes.
While behavioral finance focuses on the human behavior that often harms investing and financial decisions, it highlights a handful of benefits such as greater self- and social-awareness, greater analysis and awareness of biases and a better understanding of market behavior overall.
Why Should Finance Professionals Understand Behavioral Finance?
For individual investors, decision-making is often determined, in part, by their states of mind. As their emotions and mental conditions change, often due to internal biases and the influences of the investing herd, their ability to reason about money and their financial decisions are often negatively impacted.
One of the most important responsibilities a financial planner has is to mitigate the risks of emotional decision-making by educating clients about risk profiles and asset allocation and helping clients stay true to their long-term plans. At times, it helps to explain behavioral finance concepts to clients to show them when they are making rational decisions and when they are being led astray by conscious or subconscious biases.
Financial professionals can help clients overcome behavioral finance issues by focusing on the process as well as preparing, planning and pre-committing.
Influences and Biases
People tend to make financial and investment decisions based on their biases and prior and current influences. Therefore, it is easier for advisors to help their clients if they understand the impact of the following concepts on their decisions:
Mental Accounting: Individuals tend to categorize their money into separate mental accounts based on criteria such as the source of the money, its intended purpose or its timing. This can lead them to earmark money for certain asset classes rather than to invest more opportunistically.
Herding Bias: This is the inclination of investors to follow trends, such as the dot.com bubble in the late 90s and cryptocurrencies in the current decade, for fear of missing out. Millennials are particularly susceptible to this bias.
Confirmation Bias: This occurs when investors tend to believe information confirming their pre-existing views and disbelieve information challenging those views, even if the information is accurate.
Experiential Bias: Investors can be overly influenced by their personal histories and especially recent events due to this bias, also known as recency bias. People tend to expect outcomes they have experienced recently or frequently more than outcomes they have not encountered as often. Generation X is known to exhibit this bias most often.
Anchoring Bias: Experienced investors often rely too heavily on specific reference points or pieces of information and give them too much weight in their investing decisions, even in the face of new, conflicting information. Baby Boomers have often followed this tendency.
Loss Aversion: After suffering significant losses, investors may approach future decisions more cautiously, fearing potential losses rather than remaining eager to achieve potential gains. This risk-averse tendency can cause them to lose out on the best opportunities, rather than focus on balancing risk with reward in a diversified portfolio.
Overconfidence Bias: As the opposite of loss aversion, overconfidence can lead investors to believe too much in their own abilities, take on too much risk or fail to diversify adequately.
Familiarity Bias: This bias can be controversial, as many investment advisors recommend focusing on companies that investors know and understand. This can result in an imbalanced portfolio that favors domestic investments or investments in a particular industry.
A Curriculum That Develops Behavioral Finance Skills
The online Master of Science Finance from the University of Illinois Springfield emphasizes behavioral science throughout the curriculum. In the Introduction to Financial Psychology course, students evaluate psychological effects on financial decision-making and learn related skill sets needed for financial planning, financial coaching and financial therapy. In the Applied Behavioral Finance course, students develop skills in technical analysis of market trends, trader psychology and investment planning. This course evaluates the effects of human emotions, market mood and cognitive errors on asset trading behaviors.
In a world of constantly expanding information (and misinformation) available to individual investors at their fingertips 24/7, it is more important than ever for financial planners and professionals to understand behavioral finance.
Learn more about the University of Illinois Springfield’s online Master of Science Finance program.