Updated: Jan 26
Everyone has to start somewhere. And just like you, behavioral finance didn't come out of thin air.
Behavioral finance stems from three Founding Fathers- Daniel Kahneman, Amos Tversky, and Richard Thaler, all economists who lived during the 20th century. Their work is oftentimes referred to as the “biases literature.”
But prior to the trio, George Charles Selden published one of the first books that specifically focused on psychology and finance-Psychology of the Stock Market (1912). Psychologist Leon Festinger proposed the concept of concept dissonance (1956); in which an individual experiences stress one, because of conflicting values they might have internally or two, because they have committed actions that they believe in.
Economists John Kenneth Arrow and John W.Pratt discussed the relationship risk aversion and utility in Pratt’s Theorem (1964).
The Beginning of a Revolution
Arguably, the start of behavioral finance began when Kahneman and Tversky published Prospect Theory: A Study of Decision Making Under Risk (1979).
The two strove away from the theories of traditional finance and proposed a radical idea-that the rational man does not exist. They found that investors, instead of calculating potential outcomes and choosing the best one, they actually calculate against a reference point.
Their discussion of the prospect also brought the introduction of loss aversion since loss aversion is a bias of the prospect theory. Thaler joined Kahneman and Tversky when he introduced the idea of mental accounting in a paper (1980). Thaler won a Nobel Peace Prize in 2017 for his contributions to behavioral finance as laid down the foundation for the Behavioral finance theory-that people are irrational and have a lack of self control.
Importance of Behavioral Finance
Although behavioral finance originated in the late 1970’s and early 80’s, it wasn’t until the 2008 crisis that it caught the attention of mainstream society. With investors selling their stocks in a Stock Market that was comparable to that of the Great Depression, the traditional financial advice of “buying low, selling high” was no longer applicable. In a time where people were selling due to panic, behavioral finance helped to explain why people were acting the way they were and not why they were acting in the way that they were supposed to.
For starters, the prospect theory and herding clarified why there was a mass amount of panic selling towards the end of 2009. Because investors were terrified of incurring a loss, they sold their shares in fear that they would drop even lower.
The herding behavior simply explains the sheer numbers of people that sold their stocks simply because they saw other people doing it and they didn’t want to be left with worthless assets that would eventually turn into liabilities.
Find the intersection of finance and psychology fascinating? Don't be a stranger to the behaviorism section. After all, it may help you save a few bucks.