What is behavioral finance and how to use it to invest better?

Behavioral finance for a more sustainable world

“The scientific models that had been used historically to study economic and financial systems were fundamentally based on mathematics. However, those who make investment or financing decisions are humans with cognitive limitations and emotions. Behavioral finance introduces these two great human aspects in the new financial models.

Thanks to this, we can study, in a way that is much closer to reality, the consequences that different policies and financial systems would have if implemented. For example, it has been seen that human beings, in general, are willing to lose some benefit if it benefits other people in groups with whom we empathize.

Behavioral finance is studying systems that enhance these behaviors to advance in a more sustainable world”, explains Irene Comeig, director of the Master in Corporate Finance Research + Cashlab of the Finance Department of the University of Valencia and author of the study Learning behavioral finance by experimenting.

The self-control theory

Robert J. Shiller was one of the winners of the Nobel Prize in Economics in 2013 and is also one of the most brilliant authors of the behavioral or behavioral finance current, along with Richard H. Thaler, another of the winners, this in 2017. Some say that 6% of the winners of the Nobel Prize in Economics are specialized in this type of finance.

Thaler and Hersh Shefrin, the latter a professor at Santa Clara University (USA), proposed an economic theory of self-control, which describes economic phenomena based on people’s inability to control their impulses. If we are capable of picking up a bill lying on the sidewalk, we should also be capable of resisting the urge to spend it. In other words, not everything we are capable of achieving must be spent for the fact of having achieved it. Hence the importance of saving.

In the recent financial crisis caused by COVID-19, many investors panicked and sold stocks in their portfolios en masse. However, thanks to a more favorable economic situation, the markets recovered. This means that if these investors had maintained self-control they would have lost less than they did.

This is how Fernando Javier Crecente Romero, director of Entrepreneurship at the University of Alcalá de Henares and professor in the Department of Economics and Business Management, explains it: “Behavioral finance considers how investors make decisions individually, but also collectively. , within a given context.

Its importance lies in the fact that it goes beyond the traditional rationality approach and gives greater weight to the human figure of the investor. Examples of this can be found in the expected price of the shares: a capital increase of a company will generate behaviors in investors that affect the sale price of the share. These situations also occur in the case of relations between managers and shareholders: how the personal motivations of managers can affect relations with partners, for example”.

However, let us not forget that, like any current, this one also receives criticism. They are those of those who do not understand why it is not taken into account that individuals themselves can gradually learn from their mistakes and, therefore, instinctively recognize the appearance of non-rational elements in their decisions. The Canadian-American psychologist Albert Bandura was one of the faithful defenders of this current.