An Introduction to Behavioral 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.

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.