Behavioral Finance

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What is 'Behavioral Finance'

Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.

BREAKING DOWN 'Behavioral Finance'

The efficient market hypothesis proposes that at any given time in a liquid market, prices reflect all available information. There have been many studies, however, that document long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Many traditional models are based on the belief market participants always act in a rational and self-bettering, or wealth-maximizing, manner, severely limiting these models' ability to make accurate or detailed predictions.

Behavioral finance attempts to fill this void by combining scientific insights into cognitive reasoning with conventional economic and financial theory. More specifically, behavioral finance studies different psychological biases that humans possess. These biases, or mental shortcuts, while having their place and purpose in nature, lead to irrational investment decisions. This understanding, at a collective level, gives a clearer explanation of why bubbles and panics occur. Also, investors and portfolio managers have a vested interest in understanding behavioral finance, not only to capitalize on stock and bond market fluctuations but also to be more aware of their own decision-making process.

Biases Studied in Behavioral Finance

A prominent psychological bias is the herd instinct, which leads people to follow popular trends without any deep thought of their own. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. Herd instinct is correlated closely with empathy gap, which is an inability to make rational decisions under emotional strains such as anxiety, anger or excitement.

The self-attribution bias, a habit of attributing favorable outcomes to expertise and unfavorable outcomes to bad luck or an exogenous event, is also closely studied within behavioral finance. George Soros, a highly successful investor, is known to account for this tendency by keeping a journal log of his reasoning behind every investment decision.

Many other tendencies are studied within behavioral finance, including loss aversion, or disliking losses more than liking gains; confirmation bias, or acknowledging confirmatory evidence while ignoring contradictory evidence; availability bias, or judging outcomes by previous experiences of similar outcomes; disposition effect, or selling investments after little gains but hanging on to them even after significant losses; and familiarity bias, or preferring familiar rather than new investment opportunities.

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