Behavioral finance is a school of financial theory that aims at explaining financial market anomalies that traditional finance theories cannot explain. Behavioral finance accounts for human irrationality and the faults that lie in the formulation of the heuristics they use to make the investment decisions.
Making an investment decision is dependent on various factors, both quantitative and qualitative. However, many investors, be it individuals or large investing institutions tend to only rely on quantitative factors which are primarily driven by traditional financial research theories.
Traditional finance theories are built on one big assumption: that investors are rational and will act in self interest. The problem with this approach is that while financial markets are driven by basic mathematical principles and axioms, investment decisions are still a function of human interaction and decision making.
Behavioral finance challenges the assumption that individuals act rationally by considering all information before they make decisions. It provides an alternative view on the inconsistencies of financial markets and seeks to explain phenomena that traditional finance just cannot.
Behavioral finance theories establish that human behavior is riddled with biases and judgements, which could be cognitive or emotional. When observing capital markets with this lens, investors are likely to get a more holistic picture of the market and thus are more likely to make better decisions.
Behavioral biases come in two forms
Cognitive Biases: These biases are driven by the inability to process information due to the misinterpretation of information or due to poor quality information.
Emotional Biases: These biases are driven by the inability to process information due to the way the individual feels about the topic at hand.
These biases result in the creation of “heuristics” which are mini frameworks that lead to a decision being made. As an investor, one needs to be conscious of the heuristics they employ to make an investment decision, as they may not be evaluating the investment opportunity objectively. The quality of the heuristics employed can make or break an investment portfolio.
Behavioral biases are prevalent across all markets for all financial instruments. Over the next few months, we plan to explore the prevalence of behavioral biases in private market investment decisions as well as in the decisions made by founders of startups.