Behavioral Finance Theory

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Behavioral Finance Theory

Behavioral finance is a relatively new branch of finance that studies how investor psychological biases and market behavior can affect financial decisions. One of the main theories of behavioral finance is “Prospect Theory”, developed by Nobel Prize-winning economist Daniel Kahneman and Amos Tversky.

Prospect theory demonstrates that an individual’s investment decisions are greatly influenced by their perception of risk and their feelings of loss. Simply put, humans will take on more risk when they perceive it to be inconsistent with their current values and will favor losses over gains. Thus, individuals prefer to insure themselves against potential losses.

Kahneman and Tversky also identified four psychological biases that may play a role in influencing investment decisions. First, there is the “herd mentality” which refers to the tendency for investors to follow the crowd and mimic the behavior of others. Second, the bandwagon effect is the tendency for people to be more willing to invest if they know others are already doing so. Third, anchoring bias refers to the tendency of investors to focus on their initial investment decision and ignore new information that may prove it to be wrong. Finally, the status quo bias is the tendency for people to prefer to respond in the ways they have previously done, as they prefer comfort and familiarity.

Another concept of behavioral finance is the Behavioral Gap, which is defined as the difference between what an investor expects to achieve in a given period of time and what they actually achieve over that same period of time. This gap is caused by various psychological biases in decision making, such as over-analyzing investments, failing to diversify one’s portfolio, or relying on new and incomplete information.

The concept of behavioral finance provides insight into why investors may at times demonstrate irrational behavior. For example, an investor may be more comfortable with a risky investment if it is endorsed by a trusted friend or advisor, despite the fact that it may not be the best decision from a financial perspective. This type of behavior goes against the basic tenets of traditional finance, which would suggest that one should always make decisions based primarily on the financial implications of their choice.

In conclusion, behavioral finance offers a unique perspective on how humans make financial decisions and how emotions can sometimes trump logic when making investment choices. Prospect theory, the behavioral gap, and psychological biases can all help explain why investors deviate from the ‘rational’ approach to making financial decisions. Understanding this can help both novice and experienced investors to make better investment decisions, and thereby potentially achieve better financial outcomes.

Behavioral finance is a relatively new field of study which combines the principles of finance and psychology, often to identify irrational actions and situations in the financial industry. The underlying premise of behavioral finance is that individuals often act irrationally in financial decisions, while the traditional approach assumes an idealized rational person.

Traditional finance theory uses a rational investor who tries to optimize their gains by making the most sensible decisions. This approach, known as expected utility, suggests that individuals aim for maximum returns in light of all available information. Behavioral finance challenges this notion by introducing elements of psychology and rational inattention, suggesting that common mental shortcuts can negatively affect decisions. Among these mental shortcuts is the tendency of individuals to overestimate their own abilities.

When investors overestimate their abilities, this creates cognitive bias, the idea that peoples expectations are skewed due to their perceptions of the world. This bias can lead to deleterious actions, such as over- or under-investing in certain assets or investing in assets beyond their risk tolerance. Moreover, individuals often succumb to emotions like fear and greed that can cloud their judgment and lead to costly mistakes.

In order to better understand and regulate the behavior of human investors, as well as for better targeting of investments, a range of approaches can be used, encompassing mathematical models, cognitive psychology and game theory. These techniques aim to identify common psychological pitfalls and emotional motivation factors in order to make more informed decisions.