What Is Behavioral Finance?

Behavioral finance studies how psychology influences the behavior of investors and how their decisions affect financial markets.

Written by Matthew Urwin
Published on Dec. 16, 2021
What Is Behavioral Finance?
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Kristen Pascoe | Aug 12, 2022

People are driven by unconscious biases and other influences, behavioral finance proposes that irrational choices can explain market trends. It then becomes essential to explore why investors make decisions that don’t follow logical thinking and may end up hurting them in the long run.

What are the branches of behavioral finance?

  • There are several types of behavioral finance and many factors that influence financial decisions, including overconfidence, familiarity bias, hindsight bias and more. 

When analyzing why individuals do or do not invest, it’s important to remember that people may follow an irrational process. Some people may choose to avoid a certain fund because they are unfamiliar with the company. If someone feels like they have a lot to lose, they may also succumb to loss aversion and avoid taking a chance. At the other end of the spectrum, investors may flock to a stock because they are buoyed by overconfidence when they see the initial stock price.

Multiple types of behavioral finance can guide investors down a specific path, so it’s crucial for people to understand the various biases that can control outcomes. These behavioral finance biases include:

  • Overconfidence, or the profound belief in results accomplished in small sample sizes
  • Familiarity bias, or the primary reasoning of an investment being that one is interested or involved in a particular company
  • Hindsight bias, or the belief that a past investment result will be repeated in a future investment
  • Naive diversification, or investing in a numerous amount of funds without targeted reasoning
  • Belief perserverance, or the refusal to accept new information when making investment decisions.

How is behavioral finance different from traditional finance?

  • While traditional finance focuses on the market, behavioral finance factors human behavior into the equation.

Traditional finance assumes that markets are efficient and that it’s impossible to predict how stock prices will change. As a result, this method homes in on market behavior and financial models. 

Meanwhile, behavioral finance shifts the focus toward human emotions, which has led to the growth of emotion AI technology in finance. This discipline argues that people make irrational decisions and that markets respond to these decisions. For example, believers in conscious consumerism may invest in a company to stay true to their sense of justice. Behavioral finance considers these kinds of choices, revealing how human thinking can alter market results.

What are the benefits of behavioral finance?

  • Understanding the principles of behavioral finance can help investors avoid mistakes and make smarter decisions.

To gain financial independence, investors need to exercise the independent thinking that comes with behavioral finance. When investors are aware of the power emotions can have in decision-making, they’ll be better equipped to avoid making decisions based on fear. Keying in on behaviors enables investors to discover patterns, making it easier to predict how people and markets will behave in similar situations. By becoming aware of emotions, investors can manage their own emotions and navigate everyday challenges, such as confirmshaming techniques. Behavioral finance then gives investors the tools to better care for their financial and personal well-being.

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