You’ve probably heard about the crack of 29, the Volkswagen case, or the WHO opinion on meat products. Since the 90s, there is a prevailing philosophy that states that markets are clearly influenced by psychology and human behavior. Behavioral finance explains how these elements affect the market economy.
Behavioral finance, unlike other financial models, is based on the theory that economic agents are not rational, that is, how emotions, beliefs, and context affect decision making. This thinking helps to explain some of the inefficiencies of the markets, the great variability of agents’ preferences and the way in which information is processed.
As it is a model of non-rational agents, two fundamental issues must be taken into account. On the one hand, information, that is, when agents receive new news, will update their beliefs; and on the other, the subsequent decision-making based on those beliefs and information received.
In this way, behavioral finances confirm some suspicions that experts have been observing for some time:
-Investors tend to overweight data that comes quickly to mind, that is, there is a first emotional analysis on a rational one.
-Many investors react with greater suffering to the loss of income than with pleasure to the profits, which affects factors such as risk and investment.
-It tends to persist in error, resulting in the repetition of non-beneficial actions.
The list of elements that characterize the behavior of non-rational agents is very long, but the experts point out the following as the main ones:
– Heuristic decisions: The need to seek the solution of a problem through non-rigorous or rational methods, that is, through approximations.
-Emotional and visceral factors: Investment psychology varies depending on multiple emotional issues: marital status, sentimental, etc.
-Election from a framework: Traditional market models pursue the maximization of utility, but in practice, economic agents make decisions with a shorter time horizon than their lives. Investments are made in the short or medium term.
-Context: The economic, social, and political situation is decisive. Like the staff. Investors will not make the same decisions in good times as during an economic crisis.
In 2010, it was realized that investors from Eastern Europe have a greater aversion to losses than Anglo-Saxons, more tolerant. Africans stand out for their impatience when it comes to investing, compared to Germans and Nordics. The common feature of all regions is to increase the risk after having experienced economic losses.
Behavioral finances would explain market behavior in the face of shocking events and news in different sectors. The most recent has been the WHO report published on processed meat products. This could affect the food industry in many countries, such as Spain or Germany. By affecting the consumption habits of the inhabitants, who would be reluctant to purchase these products, investors could end up diverting their funds to other sectors.
In a similar case, the news of the manipulated reports of the Volkswagen brand has not affected only that company but the sector as a whole and many other organizations. In this case, it would be questions of branding and business philosophy. Some investors will opt for other companies by not wanting to see their funds linked with a reputation in between.
According to experts in behavioral finance, four types of investors could be distinguished:
-Investor Explorer: he is very familiar with the financial markets but relies on the emotions when making decisions. They are dazzled by new products and trends, so they end up abandoning their strategies for emotional reasons.
-Intuitive investor: has no investment strategy, loses sight of economic objectives, and is influenced by the evolution of the market.
– Realistic investor: usually lacks financial knowledge to assess risks and opportunities, but leaves aside their emotions. It is normal that they are advised by experts.
-Strategic investors: has a strong investment strategy and knows the market, so they make objective decisions based on the data.
Behavioral finance shows that the market is a profoundly changing environment and trying to foresee its movements is a complicated task. The elements that affect investments are innumerable, and the experts know that behind every figure there is a person and an emotion.
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