What is Behavioral Finance?
Behavioral finance is the study of how psychological factors influence the behavior of investors or financial analysts. It is a topic closely related and a part of behavioral economics. Behavioral finance suggests that psychological influences and biases can affect an investor or financial analyst’s behavior. It also attempts to explain the sources for all types of market anomalies, especially in the stock market.
There are various perspectives through which one can analyze behavioral finance. It is mostly relevant to stock markets and returns for investors. It is an area that behavioral finance suggests psychological behaviors can influence market outcomes and returns. It is because investors can look at these factors in different ways.
What are the differences between Behavioral and Traditional Finance Theories?
The behavioral finance theory goes against the traditional finance theory in some aspects. The traditional finance theory treats the market and investors as perfectly rational. However, the behavioral finance theory treats investors as “normal” not “rational”. The traditional finance theory also suggests that investors have perfect self-control. In contrast, the behavioral theory suggests investors have limits to their self-control.
The traditional finance theory also suggests that investors truly care about utilitarian characteristics. However, the behavioral finance theory implies that investors get influenced by their own biases. Lastly, the traditional finance theory also suggests that investors don’t allow cognitive or information processing errors to affect their decisions. The behavioral finance theory believes that investors make cognitive errors which can lead to wrong conclusions.
What are the concepts in Behavioral Finance?
Behavioral finance has five main concepts. The first concept is that of mental accounting. It refers to the propensity for people to allocate money for specific purposes. Behavior finance also includes herd behavior. This concept suggests that financial participants are likely to imitate the financial behavior of the majority.
Behavioral finance also consists of the emotional gap concept. It refers to decision-making based on extreme emotions or emotional strains. It suggests that investors may allow emotions, such as anxiety, anger, excitement, or fear to influence their decisions. Behavioral finance also proves that emotions are often the primary factors for irrational decisions.
The fourth concept within behavioral finance is anchoring. It refers to attaching a spending level to a particular reference. It can give rise to anchoring bias which can cause investors to make incorrect financial decisions. Lastly, behavioral finance also includes the concept of self-attribution. It refers to the tendency of financial participants to make choices based on confidence in self-based knowledge.
What are the different types of biases in Behavioral Finance?
Behavioral finance tries to explain the impact of personal biases on investors and their decision-making. These biases may relate to various factors and can stem from several sources. Among the top biases in behavioral finance, the most prevalent ones are as below.
- Overconfidence in investing and the illusion of control.
- Hindsight bias.
- Anchoring bias.
- Herding mentality.
- Confirmation bias.
- Self-attribution bias.
- The narrative fallacy.
- Representative bias.
- Framing bias.
- Loss aversion.
Conclusion
Behavioral finance is a sub-field in behavioral economics. It studies how psychological factors can influence the behavior of financial participants. It also seeks to explain the sources for an explanation for all types of market anomalies. There are various concepts in behavioral finance. Similarly, it also has different types of biases.
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