What is Behavioral Finance?
Behavioral finance is used to apply psychology-based theories to help explain the actions of investors and stock market fluctuations. The ideas regarding behavioral finance incorporate individual and social psychology with financial hypotheses to help explain the performance of the stock market. The underlying concept is that emotional reactions resulting from these psychological variables have an impact on both market and overall economic conditions. Behavioral finance is used to explain the irrational behavior of investors.
Where Did the Study of Behavioral Finance Come From?
While tools and formulas (like the capital asset pricing model and efficient market hypothesis) have been created to help predict and explain economic events and market conditions, many circumstances have developed that have been outside of rational explanation. The ‘real world’ of finance entails complexities that can only be accounted for through the introduction of investor behavior.
Key Concepts within Behavioral Finance
Behavioral finance seeks to describe market inefficiencies, specifically, under-reactions and over-reactions to information. These types of inappropriate reactions have, in extreme cases, been attributed to market crashes and speculative bubbles. In fact, some financial models leverage known financial behaviors in setting parameters for portfolio management and asset valuation exercises.
There are three primary themes within behavioral finance.
Heuristics: The idea behind heuristics is that investors often make decisions based on their own values, ideas, or rules of thumb. These ideas may not follow any identifiable or logical pattern and may not seem rationale to others.
Framing: The framing aspect within behavioral finance refers to how the data is presented to the investor and the impact that may have on their decision. According to the theory, the tone and other aspects of conveying the information can significantly impact the actions the investor chooses to take.
Market Inefficiencies: Market inefficiencies describe outcomes within the market that are contrary to what one might rationally expect given a set of conditions. This area looks for the contributing factors that may have played a role in the unexpected outcome.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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