Behavioral finance studies the influence of psychology and sociology on the behavior of investors and how this can impact the financial markets.
This is important because it helps to explain why markets are inefficient and why factor premiums exist. Behavioral Finance assumes that investors are not fully rational in their actions, but rather constantly allow their decisions to be influenced by human emotions. These emotions elicit irrational decisions, also known as biases or prejudices.
One example of this is the herding instinct: the shared tendency of investors to want to take the same decisions at the same time. This can be explained by the fact that investors do not want to run the risk of seeing returns on their portfolio fall short of returns realized by others. We are all familiar with the example of herding that occurred during the Internet bubble in the late 1990s. One of the main reasons that investors bought technology stocks at that time was because they saw others earning money with them.
A second example is anchoring: the investors’ tendency to focus on irrelevant information when making their investment decisions. They prefer not to sell stocks at a price below their purchase price and so hold on to them for too long in the hope of recouping their losses. As a result of anchoring, stock prices tend to only gradually respond to news which is a possible explanation for the Momentum factor.
Gaining an understanding of investor behavior through academic research plays an important role in establishing an explanation for factors and factor premiums and assessing the extent to which they will be sustainable in the long term.
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