Behavioral finance is a field of study that combines psychology and economics to understand how people make financial decisions. Unlike traditional finance, which assumes that investors are rational and markets are efficient, behavioral finance recognizes that investors often behave irrationally due to cognitive biases and emotions.

Example

Imagine you see a shirt you like at a store:

1) Option A: The shirt is originally 4,000, but it’s on sale for 2500.

2) Option B: The shirt is priced at 2500.

Behavioral finance suggests you might prefer Option A because you feel like you’re getting a better deal. Seeing the original price makes you think you’re saving money, even though you pay the same amount in both options.

Key concepts of behavioural finance

1) Cognitive Biases:

Overconfidence: Investors may overestimate their knowledge and ability to predict market movements, leading to excessive trading and risk-taking.

Anchoring: Investors might rely too heavily on the first piece of information they receive (the “anchor”) and fail to adjust their views adequately based on new information.

Herding: Investors tend to follow the crowd, buying or selling assets because others are doing so, which can lead to market bubbles or crashes.

2) Emotional Factors:

Fear and Greed: Emotions like fear and greed can drive decision-making, leading investors to sell in panic during downturns or buy excessively during booms.

Loss Aversion: People are more sensitive to losses than to gains, which can make them hold onto losing investments for too long or sell winning investments too early.

3) Mental Accounting:

Investors often treat money differently based on its origin or intended use. For example, they might be more willing to take risks with money won from gambling than with their salary.

4) Prospect Theory:

Developed by Daniel Kahneman and Amos Tversky, this theory suggests that people value gains and losses differently, leading them to make decisions based on perceived gains rather than actual outcomes.

Behavioral finance explains that markets are not always efficient because investor behavior is influenced by psychological factors. This understanding helps in identifying market anomalies and developing strategies that consider human behavior. By recognizing these biases and emotions, investors can make more informed and rational decisions, potentially improving their financial outcomes.