What is Behavioral Finance?

Definition of behavioral finance

Behavioral finance is the study of the effects of personal biases and psychological influences on traders or investors. Simply put, researchers try to analyze why individuals often make irrational financial decisions and lose money. Understanding these reasons can help make better financial choices.

Experts also use behavioral finance concepts to analyze the impact of emotions on the financial market, as they sometimes lead to sudden ups and downs in asset prices.

Basic biases in behavioral finance

Behavioral finance theory states that instead of being rational and calculating, people often make financial decisions based on emotions and cognitive biases. Here are five basic biases:

Loss aversion is the tendency of an individual to make more sense of losses than of the same amount of profit. For example, it is better not to lose $100 than to find $100, because the pain of losing is greater than the pleasure of gain. As a result of this bias, the trader concentrates on loss avoidance, while financial opportunities are missed.

Overconfidence biasis the tendency for a person to overestimate their abilities and knowledge, which can lead to wrong decisions in the presumptuous hope of outplaying the stock market.

The narrative fallacy is the tendency for individuals to abandon evidence in favor of a good story. This means that traders may be drawn to less promising stocks just because their company has a better history.

Anchoring biasoccurs when people rely too much on the first piece of information they get. For example, when buying any stock, many traders first look at the 52-week high or low price of that particular stock. This initial information is the “anchor.”

Herding bias is the propensity of traders to imitate the actions of the crowd without regard to their own thoughts and knowledge. Herd instinct explains why investors buy in bull markets and sell in bear markets.

Confirmation bias is the tendency of people to pay close attention to information that confirms their beliefs while ignoring information that contradicts them.

The findings of behavioral finance

Unlike traditional financial theory, behavioral finance theory includes the following beliefs:

Traders and investors are not always rational;

They often make financial decisions based on emotions and cognitive biases;

Market anomalies can sometimes be explained by psychology.

Understanding financial behavior can help people manage their money more rationally.

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2024-05-20 • Updated

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