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What is Behavioral Finance?

Updated: Jan 17, 2021

Hint hint, it's also referred to as behavioral economics.

What is Behavioral Finance?

Behavioral finance is a subfield of behavioral economics. But at its core, behavioral finance is a relatively new field of study that analyzes the financial behavior of individuals. In other words, theorists of behavioral finance study the psychology of financial decision-making. The basis is that investors rarely behave according to the general assumptions made in the traditional finance theory.

What Does It Argue Against?

Behavioral finance argues that people are the opposite of rational since they make judgements based on their emotions and biases; that people do not have self-control and that self control is limited. This idea of self-control being unsustainable is why a key component of behavioral finance states that markets are volatile, hence the existence of market inconsistencies.

Because people are victim to factors such as herding and loss aversion, this can serve as an explanation to sudden market anomalies whether it be a sudden drop or drastic increase in price.

The Main Principles of Behavioral Finance

The main principle of behavioral finance is that financial participants are illogical and have a lack of self-control. This takes into account that people can be psychologically influenced and accounts for this normalcy.

It is considered normalcy because researchers of behavioral finance are aware that it is ingrained in human nature to be influenced by certain circumstances. It’s like how you just have to have that pint of ice cream or that pizza on a late Friday night; you have no self control. Because of this normalcy, there are limits to self-control as all humans divert back to their flaws in one way or another.

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One huge key component of behavioral finance is that investors are influenced by their own biases. It typically encompasses five of these main concepts: mental accounting, herding, anchoring, overconfidence, and loss aversion that we discussed.

Don't know what those mean? Click on the links to read more.

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