1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

Whether it’s unnecessary anchoring, availability bias, or simply following the herd, chances are that we’ve all been guilty of at least some of the biases and irrational behaviors that we’ve explored in the previous chapters of this tutorial. However, armed with the awareness of some of the biases we regularly take into our financial practices, you can now apply that knowledge to your own investing in order to take corrective action where necessary. Hopefully, your future financial decisions will be somewhat more rational and a lot more lucrative as a result.

In summary, here is what we covered over the preceding chapters:

  • Conventional finance utilizes theories that assume people act logically and rationally. However, the presence of anomalies eventually revealed that individuals don’t always behave in this way, and conventional finance models have a difficult time explaining these behaviors.
  • Behavioral finance was the result of this discovery. It was pioneered by psychologists like Drs. Daniel Kahneman and Amos Tversky as well as economists like Richard Thaler.
  • Anchoring is a bias described by behavioral finance. It reflects our tendency to attach (or “anchor”) our thoughts around a reference point, whether or not that reference has any logical bearing on the decision at hand.
  • Mental accounting captures our tendency to divide money into different accounts based on criteria such as the source of the money and the intended spending. The importance placed on each account also varies.
  • Confirmation and hindsight biases prove that seeing is not necessarily believing. A confirmation bias shows that people tend to be more attentive toward new information which confirms a preconceived opinion or belief. Hindsight bias, on the other hand, explains why we might believe that, after the fact, the occurrence of an event was obvious.
  • When we incorrectly believe that the occurrence of an independent event somehow makes another unrelated independent event less likely to happen, we are falling prey to the gambler’s fallacy.
  • As individuals, we tend toward herd behavior: this reflects our propensity for following the decisions of a large group, whether or not those decisions are rational.
  • Many investors tend to be overconfident, believing that they are better able to perform a certain action or task than they actually are.
  • Overreaction refers to our tendency to react to a piece of new information with a disproportionately strong response.
  • Drs. Kahneman and Tversky developed prospect theory to reflect the way that people interpret gains and losses differently. On average, individuals tend to be more sensitive to a loss than to a gain of equal value.

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