Behavioral Finance:
Behavioral Finance is a field that combines psychology and economics to explain why people often make irrational financial decisions. Unlike traditional finance, which assumes that investors are rational and markets are efficient, behavioral finance recognizes that people are influenced by cognitive biases and emotional reactions.
Key Concepts in Behavioral Finance
Cognitive Biases
Mental shortcuts or errors in thinking that affect decision-making:
- Overconfidence: Overestimating one’s own knowledge or ability.
- Anchoring: Relying too heavily on the first piece of information encountered.
- Confirmation Bias: Favoring information that supports existing beliefs.
Emotional Influences
Emotions like fear and greed often override logic:
- Fear can lead to panic selling.
- Greed may lead to speculative bubbles.
Herd Behavior
Following the crowd, especially in uncertain situations, even when it may not be rational.
Loss Aversion
The pain of losing is psychologically about twice as powerful as the pleasure of gaining. This leads investors to hold onto losing investments too long.
Mental Accounting
Treating money differently depending on its source or intended use, rather than seeing it all as part of one portfolio.
Real-World Applications
- Market Bubbles & Crashes: Behavioral finance helps explain why bubbles (like the dot-com or housing bubbles) form and burst.
- Investor Education: Financial advisors use these insights to help clients make more rational decisions.
- Policy Design: Governments and institutions may design “nudges” to encourage better financial behaviors (e.g., automatic enrollment in retirement plans).
Behavioral Finance vs Traditional Finance
Traditional Finance Behavioral Finance Rational behavior Irrational behavior Efficient markets Market anomalies exist Objective decisions Emotional and biased decisions
Shervan K Shahhian
LIBERTY PSYCHOLOGICAL ASSOCIATION 