Behavioral Finance

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There was a time when theoretical and empirical evidence seemed to suggest that conventional financial theories were reasonably successful at predicting and explaining certain types of economic events. Nonetheless, as time went on, academics in the financial and economic realms detected anomalies and behaviors which occurred in the real world but could not be explained by any available theories.

It became increasingly clear that conventional theories could explain certain “idealized” events—but that the real world was, in fact, a great deal more messy and disorganized, and that market participants frequently behave in ways that are irrational, and thus difficult to predict according to those models.

As a result, academics began to turn to cognitive psychology in order to account for irrational and illogical behaviors which are unexplained by modern financial theory. Behavioral science is the field that was born out of these efforts; it seeks to explain our actions, whereas modern finance seeks to explain the actions of the idealized “economic man” (Homo economicus).

Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to explain financial anomalies, such as severe rises or falls in stock price. The purpose is to identify and understand why people make certain financial choices. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

Daniel Kahneman and Amos Tversky, who began to collaborate in the late 1960s, are considered by many to be the fathers of behavioral finance. Joining them later was Richard Thaler, who combined economics and finance with elements of psychology in order to develop concepts like mental accounting, the endowment effect, and other biases that have an impact on people’s behavior.

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