Without a doubt, one of the most fascinating areas in finance is the relatively new field of Behavioral Economics or Behavioral Finance. This field combines the theory of cognition in psychology with conventional finance and economics in an attempt to explain why people consistently make irrational decisions with their money.
The Godfathers of this discipline are Daniel Kahneman and Amos Tversky, with Richard Thaler credited as bringing forth new ideas and a modernization of the subject. If you are interested in finance, psychology, or have a general interest in why our brains often fail to make rational decisions, check out the two books below:
Thinking Fast And Slow:
https://www.amazon.com/Thinking-Fast-Slow-Daniel-Kahneman/dp/0374533555
Misbehaving:
Conventional finance asserted that people were rational thinking “wealth maximizers” and that theories such as the Efficient Markets Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM) were enough to explain investor behavior. In short, investors aren’t influenced by extraneous factors or their emotions when making decisions. (LOL!)
Nothing could be further from the truth, much to the chagrin of Eugene Fama. If the EMH were correct and emotions played no part in decision making we wouldn’t have stocks doing this:
This is a chart of Dryships $DRYS that shows the stock going from about $11 to $73 and back to $4 in a month’s time. Do the underlying fundamentals of a company change enough to warrant that kind of move in that amount of time? No. Sorry Eugene.
What does cause this kind of reaction is emotion. Emotion obviously plays a part in almost all aspects of our decision making processes as human beings, and to think that it doesn’t is absurd. A few of the cognitive errors as they relate to finance are as follows:
Saliency Bias: The tendency of individuals to attach major importance to a rare but serious event. (I’m not getting back into stocks because of the Flash Crash).
Sunk-Cost Fallacy: Continuing a behavior or endeavor because time, money and other resources have been previously committed. (I bought a $50 ticket to go see a concert and don’t want to go anymore. I’m sick and there is a blizzard, but I’m going any way. I don’t want to feel regret.)
Anchoring Effect: Effect which draws up the tendency to attach thoughts to a reference point even though the reference point may have no logical relevance to the decision at hand. (A diamond engagement ring should cost between 2-3 months’ worth of a man’s salary).
These are just a few of the judgement errors we make almost daily. There are many, many more.
You Aren’t Very Smart:
http://lifehacker.com/this-graphic-explains-20-cognitive-biases-that-affect-y-1730901381
Before I totally lose you (if I haven’t already) the point of the post is that there is a HOT new book about to drop. Michael Lewis (think Moneyball, Flash Boys, etc) is out with “The Undoing Project…
If you are interested in this topic, you might want to set aside the book(s) you are currently reading. Every one else will be reading this book in the next few weeks and because of that I will be too. See what I did there?