What is behavioral finance?
Behavioral finance is an area of finance that studies the effects of psychological factors on financial decisions. Behavioral finance has its roots in psychology and behavioral economics. It is concerned with how people make decisions, and how those decisions affect financial markets.
A theory of finance that attempts to explain the decisions of investors by viewing them as rational actors looking out for their self-interest, given the sometimes inefficient nature of the market. Tracing its origins to Adam Smith’s The Theory of Moral Sentiments, one of its primary observations holds that investors (and people in general) make decisions on imprecise impressions and beliefs rather than rational analysis. A second observation states that the way a question or problem is framed to an investor will influence the decision he/she ultimately makes. These two observations largely explain market inefficiencies; that is, behavior finance holds that markets are sometimes inefficient because people are not mathematical equations. Behavioral finance stands in stark contrast to the efficient markets theory.
Behavioral finance is the study of the influence of psychology on the behavior of investors or financial analyst. It assumes that investors are not always rational, have limits to their self-control and are influenced by their own biases. For example, behavioral law and economics scholars studying the growth of financial firms’ technological capabilities have attributed decision science to irrational consumer decisions. It also includes the subsequent effects on the markets. Behavioral Finance attempts to explain the reasoning patterns of investors and measures the influential power of these patterns on the investor’s decision making. The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants. Such errors affect prices and returns, creating market inefficiencies.
Behavioral finance explained
There are many different aspects to behavioral finance, but one of the most important is understanding how people make decisions. This includes factors such as emotions, biases, and heuristics.
Behavioral finance can help us to understand why people make the financial decisions they do. It can also help us to find ways to improve those decisions. In many cases, it can help us to make better decisions ourselves.