Behavioral Finance (2024)

FAQs

What is the concept of behavioral finance? ›

So, what is behavioral finance? It's an economic theory that explains often irrational financial behavior, such as overspending on credit cards or panic selling during a market downturn. People often make financial decisions based on emotions rather than rationality.

A key instance of behavioural finance in practice is the concept of Herd Mentality, where investors tend to follow the crowd. This behaviour is particularly common in stock market trends.

Behavioral financial advice equips advisors with the tools to identify and address cognitive biases and emotional influences that may hinder sound decision-making. For example, economic stress can push clients to abandon long-term plans or take on too much risk.

Behavioral finance consists of three themes: (1) heuristic‐driven bias; (2) frame dependence; and (3) inefficient markets.

And yet, there is no dearth of investors making irrational decisions. Clearly, something else is at play here – cognitive bias and limits to arbitrage. These are the two pillars of behavioural finance.

Behavioral finance asserts that rather than being rational and calculating, people often make financial decisions based on emotions and cognitive biases. For instance, investors often hold losing positions rather than feel the pain associated with taking a loss.

Behavioral finance is finance with normal people in it, people like you and me. Standard finance, in contrast, is finance with rational people in it. Normal people are not irrational. Indeed, we are mostly intelligent and usually 'normal-smart.

Benefits of behavioral finance

This may help individuals make better choices regarding their financials, which often positively impacts the economic market. Additionally, behavioral finance shows investors ways to overcome negative bias in their financial decision-making.

The idea that applying behavioural finance concepts is easy is nonsense. It is far far easier to give in to our ingrained dispositions which are natural and make us feel good – that's why everyone does it. Improving our investing behaviour means going against our own instincts and often what other people are doing.

How to study behavioural finance? ›

Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one area of finance where psychological behaviors are often assumed to influence market outcomes and returns but there are also many different angles for observation.

Behavioural finance theory ignores the impact of social status on investment decisions. Some investments are made only to increase social status and investors do not care about the economic impact of such investments e.g. people purchase expensive houses and other goods to to 'keep up with the Jones's'.

The Efficient Market Hypothesis states that prices are right and that there is no strategy that consistently beats the market. On the other hand, behavioral finance states that prices are not always right due to several human biases but it does not present clear and easy ways to beat the market.

asserts that behavioural finance seeks to understand and predict systematic financial market implications of the psychological decision process. Glaser et. al. considered Behavioural finance as a subdiscipline of behavioural economics, incorporating findings from psychology and sociology into its theories.

While researchers are continually adding to our knowledge in this field, six established tenets of behavioral finance will add greatly to an understanding of investors. The six are: Loss aversion, anchoring, familiarity bias, mental accounting, the gambler's fallacy, and herd behavior.