An Introduction to Behavioral Finance - Deepstash
An Introduction to Behavioral Finance

An Introduction to Behavioral Finance

investopedia.com

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Behavioural finance

Behavioural finance

Behavioural finance is a subfield of behavioural economics. It argues that when people make financial decisions like investing, they are not nearly as rational as traditional finance theory predicts.

Mainstream theory make assumptions in its models that people are rational and free from emotion or the effects of culture and social relations. But behaviourists think that people make financial decisions based on emotions and cognitive biases.

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Losses versus significance of gains

An example of irrational behaviour:

Offer someone a choice of

  1. a sure $50 or,
  2. on the flip of a coin, the possibility of winning $100 or winning nothing.

Chances are people will choose the sure $50.

But offer a choice of

  1. a sure loss of $50 or
  2. , on a flip of a coin, either a loss of $100 or nothing.

and the person will probably pick the last option.

In reality, the chance of the coin landing on one side or the other is equivalent in any scenario. But people view the possibility of regaining a loss as more important than a greater gain.

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The herd instinct

The herd instinct

The herd instinct. People tend to imitate others. Investors may fear that others know more or have more information and will tend to do what others are doing.

Behaviour finance has also found that investors tend to rely on judgments derived from small samples of data or single sources. For example, investors are often overconfident in their judgments and tend to go for the single "telling" detail instead of the obvious range.

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The value of understanding behavioural finance

Behavioural finance can give us insight into how financial decisions are influenced by emotion around things like investments, payments, risk, and personal debt.

Understanding how people can deviate from rational expectations can help us make better and more rational decisions.

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