Behavioral finance links the fields of psychology and finance together to investigate what psychological influences and biases may affect financial decisions. Behavioral finance studies the psychology of market participants and examines emotions and social exchanges; as behavior patterns and biases repeat, the case for market inefficiencies and technical analysis increases.
Errors in reasoning are called cognitive biases or cognitive errors. These errors often come from a disconnect between a heuristic judgement and reality. Behavioral finance believes cognitive errors that influence investor decision-making lead to market inefficiencies.
Investor rationality is the first assumption of the efficient market hypothesis. If investors routinely make cognitive errors, then investor rationality is called into question as suboptimal behaviors of investors refute the assumptions of efficient markets.
Cognitive errors are divided into belief perseverance biases and information processing biases. Belief perseverance biases study how stubborn people can be when receiving new information.
For example, will investors consider new information if it conflicts with previously held beliefs?
Information processing biases determine if new information is received rationally. For example, will the investor logically consider the information or will they unintentionally frame it in their context?
Behavioral biases are deeply held feelings and views and are often more difficult to overcome than cognitive errors.
Behavioral finance includes topics and concepts such as prospect theory, risk aversion, mental models, investor biases, and herd mentality. By taking psychological factors into account through the study of behavioral finance, investors seek to make better-informed investment decisions.
Behavioral finance and technical analysis go hand-in-hand. Behavioral finance highlights the relationship between psychology and securities prices because human psychology often involves repetitive behavior, and those repeated behaviors may lead to patterns in securities prices. The repetitions in security prices lead to repeatable signals from chart patterns, trend indicators, and other forms of technical analysis.
If behavioral finance aids in explaining securities prices, and supports technical analysis, then tenants of the efficient market hypothesis weaken. If securities prices do not follow a random walk and investors tend to react in repeatable ways, then the efficient market hypothesis’ assertion that past security prices cannot predict future price movements is refuted.
Irrational investors are often referred to as “noise traders” and are offset by rational investors who profit from arbitrage opportunities that result from the actions of noisy traders. The actions move beyond mere trading noise, however, and are based on preferences. Risk-aversion is a preference that leads investors to make less than optimal decisions based on the probabilities of an outcome.
Therefore, the interconnectedness of behavioral finance, technical analysis, and the efficient market hypothesis is evident when viewed through the perspective of investor psychology.
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