Psychological Theories of Behavioral Finance

Behavioral economics draws its concepts from psychology and neuroscience. Therefore, the effects of behavioural finance can be identified from the knowledge of fundamental concepts from psychology and neuroscience. Psychology refers to the study of the process of individual minds and action which affect behavior in a specific context. From this definition, it is clear that psychology may affect finance behavior; hence causing some social effects on economic agents in financial markets. Behavioral finance focuses on psychological approaches, especially behavioural finance. Behavioural psychology is concerned with observed behavior. This includes the psychological factors that drive people’s decisions. Some specific concepts of neuroscience and psychology have attracted the attention of behavioural economists. Such concepts include: personality theory, behavioural psychology and social psychology.

Personality theory

Personality theory explains the characteristics of individuals that determine the consistent patterns of behaviour among individuals. The importance of personality in economic decision making has been recognized because the differences in the levels of generosity among individuals may indicate the differences of sociality. An impulsive behaviour may lead to time inconsistency and impatience in financial or economic decision making. There are various personality theories that may explain the effects of behavioral finance. Such theories are explained in the section below.

Freud’s Psychoanalytic theory

Sigmund Freud’s psychoanalytic theory analyses personality and traits. In this approach, behaviour is considered as the result of interplays between basic drives, needs and conflict. In order to establish various forces that determine personality, Freud focused on three levels of consciousness: conscious, preconscious and unconscious thought. The focus on automatic versus deliberative processing by behavioral economics reflects Freud’s distinction between conscious, preconscious and unconscious thought.

Freud also analysed instinct in the development stages of a child. Obstacles to healthy childhood development may result in fixations of children if they remain stuck on a particular stage of development. Such fixations may lead to various pathological oral, anal or phallic personalities. Freud also suggested that an individual’s personality is driven by the interactions between the pleasure principle and the reality principle. The id is driven by the pleasure principle to seek gratification of basic instincts while the ego is driven by reality principle to seek gratification in a rational, practical way. The superego guides ethical attitudes. Ego is a victim of competing pressures from the id and superego, and reality.

Because economists are often concerned with making consistent choices, personality traits may influence such economic choices. Therefore, personality causes some social effects of behavioural finance. Such social effects can be explained using Freud’s analysis of identification in personality theory. Freud suggests that identification includes narcissistic identification, goal-oriented identification, object-loss identification, and aggressor identification. Narcissistic identification involves identifying with people who are similar to oneself; goal-oriented identification is concerned with identification of oneself with successful people; object-loss identification involves identifying with lost people and objects; and the aggressor identification entails identifying with authoritative personalities.

Cognitive goals

Cognitive goals involve cognitive functioning and intelligence. Measuring cognitive skills determines the ability of individuals to solve problems. This makes the concept of behavioral finance to be objective. However, it is difficult to measure cognitive skills due to the non-monolithic nature of intelligence. Alfred Benet, Theodore Simon and William Stern developed the IQ test which focused on intelligence as an overarching characteristic. Recently, general intelligence has been classified as a hierarchy of cognitive skills. Intelligence can be described in two perspectives: fluid intelligence and crystallized intelligence. Fluid intelligence is the ability to think laterally and problem-solve while crystallized intelligence is the intelligence gained from learning and experience. Measuring cognitive skills does not only involve objectivity. It can also be affected by certain factors, e.g. cultural factors, linguistic differences, conscientiousness and motivation.

Personality tests

Personality tests involve non-cognitive tests, which are even more difficult to measure than the cognitive tests. One example of personality test was developed by Kelly, and involved role construct repertory test. In this test, respondents were asked to name some key figures e.g. father, mother doctor, and teacher. They were then required to connect between them in terms of similarities and differences. This test involved a wide range of traits, but other tests have been developed recently which involve single trait or small number of traits.

Personality can also be measured using Myers-Briggs Type Indicator (MBTI). In this approach, conscious mental activity is captured in terms of: introversion versus extroversion; intuition versus sensing; thinking versus feeling; and judging versus perceiving. This test gave rise to sixteen types of personality styles. The Big Five Theory is also another method of personality testing. In this type of personality testing, personality is tested along five dimensions: openness, conscientiousness, extraversion, agreeableness and neuroticism.

Cognitive functioning

Behavioural finance is also concerned with cognitive functioning. Cognition can be clearly linked into the focus of standard economics on rationality assumptions. Cognition and emotion are greatly affected by differences among individuals. As a result, behavioral economists have started linking cognitive functioning with emotional processing. Behavior always depends on situational cues. Self-control is also related to differences among individuals. A good cognitive functioning leads to good chances of life in adulthood. Cognition and emotion are also considered to affect the social information processing differently in different people. Therefore, finance decision making in behavioral finance is affected by cognition and emotion; which in turn result in different social behaviours.

Behavioral psychology

Behavioural finance and behavioral economics emerged from the works of behavioural psychologists. Behavioral psychologists rejected what Sigmund Freud and the psychoanalysts suggested – that behavior is subjective and speculative. They pursued objective facts through observed choices and the direct and indirect impacts of stimuli on such choices. These observed behaviours in psychology links to the game theory and observed choices and preference in economics.

Behavioural psychology was developed by physiologist Ivan Pavlov who demonstrated classical conditioning by studying the eating behaviours of dogs. Ivan found that dogs started salivating before they ate food. This was shown by ringing a bell just before the dog was given food. After some time, the dog learnt the connection between the ringing bell and food. Therefore, it started salivating every time the bell was ringed. This salivation was considered as a learned, conditioned stimulus of receiving food. Association between stimuli, actions and rewards as developed by Edward Thorndike indicates the law of effect. This law states that the actions which produce pleasure give positive reinforcement, and will most likely be repeated. The law of exercise argues that a positive association is made, it is most likely that it is to be used and vice versa. The law of recency suggests that recent events will be more salient and they will most likely be repeated. The impacts of prior events are likely to decay over time.

Behavioral psychology has influenced behavioural economics. Behavioral economics use behavioural psychology methods by focusing on choices using experimental methods and basing such choices on cognitive and processes that affect economic decision making. As technology improves, behavioral approach becomes obsolete because as technology improves, the objective information available for decision making does not depend on studying what people do. With new technology, it is now possible to objectively measure psychological responses related to observed action.

Social psychology

Social psychology entails both psychology and sociology. Sociological emphasis on group influence and context dependence is blended with psychological personality and individual differences. Sociologists study the influence of social groups and contexts on individual behaviour. In order to achieve this, sociologists differentiate between normative and informational influences. Informational influences can be used to determine the impact of social groups on individuals by analysing them in an objective way. On the other hand, normative influences include norms and influences from social groups that affect human perceptions of behaviour. Sociological forces lead to interdependence, imitation and herding. Sociological forces also interact with psychological forces to cause various impacts on individual behaviour.

Social learning theory

Social scientists suggest that learning takes place within social contexts through observation and influence from role models. External reinforcements by outside events cause subjective influence on the behaviour of individuals. In this theory, loci of control influence the behaviours of individuals. Individuals with internal locus of control take charge of their own actions while those with external locus of control view events in context, including social context. Social learning theory suggests that people usually imitate behaviors exhibited by their role models.

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