An Introduction to Behavioral Finance

Traditionally, economics and finance have focused on models that assume rationality. The behavioral insights have emerged from the application of insights from experimental psychology in finance and economics.

Behavioral finance is relatively a new field which seeks to provide explanation for people’s economic decisions. It is a combination of behavioral and cognitive psychological theory with conventional economics and finance. Inability to maximize the expected utility (EU) of rational investors leads to growth of behavioral finance within the efficient market framework. Behavioral finance is an attempt to resolve inconsistency of Traditional Expected Utility Maximization of rational investors within efficient markets through explanation based on human behavior. For instance, Behavioral finance explains why and how markets might be inefficient. An underlying assumption of behavioral finance is that, the information structure and characteristics of market participants systematically influence the individual’s investment decisions as well as market outcomes. Investor, as a human being, processes information using shortcuts and emotional filters.

This process influences financial decision makers such that they act seemingly in irrational manner, and make suboptimal decision, violate traditional finance claim of rationality. The impact of this suboptimal financial decision has ramification for the efficiency of capital markets, personal wealth, and the performance of corporations. Irrational decision could be either due to processing of wrong information or interpretation with inconsistent decisions.

Behavior finance focuses upon how investors interpret and act on information to make informed investment decisions. Investors do not always behave in a rational, predictable and an unbiased manner indicated by the quantitative models. Behavioral Finance places an emphasis upon investor behavior leading to various market anomalies.

The emergence of behavioral finance has presented a new realm for analyzing the ways in which investors make decisions that includes psychological factors as well as providing new grounds upon which it question conventional methods of modeling investor behavior. The challenge that behavioral finance assembles is aimed particularly in the direction of the efficient market hypothesis (EMH), which is the standard finance Model. Behavioral finance challenge hypothesis that standard finance model of on ‘how investor decision is inaccurate’, as it fails to include psychological and value expressive preferences in calculations.

Definitions of Behavioral Finance

Linter G.(1998) has defined behavioral finance as being study of how human interprets and act on information to make informed investment decisions.

Olsen R. (1998) asserts that behavioral finance seeks to understand and predict systematic financial market implications of psychological decision process.

According to Frankfurther and McGoun (2002), Behavioral finance, as a part of behavioral economics, is that branch of finance that, with the help of theories from other behavioral sciences, particularly psychology and sociology, tries to discover and explain phenomena inconsistent with the paradigm of expected utility of wealth and narrowly defined rational behavior.

Gilovich (1999) have referred to behavioral finance as behavioral economics and further defined behavioral economics as combining twin discipline of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they save, invest, spend and borrow money.

Definitions of Behavioral Finance

According to Shefrin (2001) Behavioral Finance is the study of how psychology affects financial decision making and financial markets.

According to Fromlet (2001) Behavioral finance closely combines individual behavior and market phenomena and uses knowledge taken from both the psychological field and financial theory.

According to M Sewell (2007) Behavioral finance is the study of the influence of psychology on the behavior of financial practitioner and subsequent effects on market. He has stated Behavioral Finance, challenging the theory of Market efficiency by providing insight into why and how market can be inefficient due to irrationality in human behavior.

W.Forbes (2009) defined behavioral finance as a science regarding how psychology influences financial market. This view emphasizes that the individuals are affected by psychological factors like cognitive biases in their decision making, rather than being rational and wealth maximizing. Behavioral finance is new approach to financial markets that argues that some financial phenomena can be understood by using models where some agents are not fully rational.

Meaning of Behavioral Finance

Behavioral finance is a discipline that attempts to explain and increase understanding regarding how the cognitive errors (mental mistakes) and emotions of investors influence the decision making process. It integrates the field of psychology, sociology, and other behavioral sciences to explain individual behavior, to examine group behavior, and to predict financial markets. According to behavioral finance people are not always rational: many investors fail to diversify trade too much, and seem to selling winners and holding losers. Not only that, but they deviate from rationality in predictable ways.

Richard Thaler (1999) states “Behavioral finance is no longer as controversial a subject as it once was. As financial economists become accustomed to thinking about the role of human behavior in driving stock prices, people will look back at the articles published in the past 15 years and wonder what the fuss was about. I predict that in the not-too-distant future, the term “behavioral finance” will be correctly viewed as a redundant phrase. What other kind of finance is there? In their enlightenment, economists will routinely incorporate as much “behavior” into their models as they observe in the real world. After all, to do otherwise would be irrational.”

Thaler’s view is likely to prove optimistic. Finance researchers are likely to be studying large, highly competitive asset markets and largely ignore behavioral modifications to traditional theory. Even relatively new field, Behavioral Finance is growing very fast, in explaining not only how people make financial decisions and how markets functions, but also how to improve them.

As the evidence of the influence of psychology and emotions on decisions became more convincing, behavioral finance has received greater acceptance. “Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic and very human departures from rationality into standard models of financial markets. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompt the second” (Barber and Odean,1999). Individual investor and their behavior had received lot of consideration and focus of interest of many scientists not only being confided only to economist, but, due to the inclusion of the findings and the methodology of psychology into financial studies. Despite many debates, this has slowly led to the establishment of behavioral economics and behavioral finance as widely recognized sub-disciplines.

Behavioral finance promises to make economic model better at explaining systematic investor decisions. Taking into consideration their emotions and cognitive errors and how these influence decision making. So behavioral finance is not a branch of standard finance; it is replacement offering a better model of investor psychological decision process.

Thus behavioral finance can be described in the following ways:

  1. Behavioral finance is the integration of classical economics and finance with psychology and the decision making sciences.
  2. Behavioral finance is an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature.
  3. Behavioral finance is the study of how investors systematically make errors in judgment or ‘mental mistakes’.

According to behavioral finance, investor’s behavior in market depends on psychological principles of decision making, which explains why people buy and sell investments. It focuses on how investors interpret information and act on information to implement their financial investment decisions. In short psychological process and biases influences investors decision making and influence the market outcomes.

Similarity and Differences between Standard Finance and Behavioral Finance

Behaviorists argues that behavioral theories are necessary to explain anomalies that cannot be accommodated by traditional finance theory. In return Traditionalist uses a philosophy of instrumental positivism to argue that the competitive institutions in finance make deviation from Homo Economicus. Traditional Finance incorporates no element of human psychology; Behavioral Finance usually incorporates almost no elements, relying on economic theory. Finance institution place people in complex settings that are best described in terms of information, incentives, and actions that can be taken –building block of economic theory. Thus, behavioral studies include only small elements of psychology, integrated into economic theory needed to understand the institution itself. In this way, Behavioral Finance adds only wrinkle to standard finance, which is to alter some of one or more facets of an assumption which is the very foundation of economic theory: how do individual behave?

The key difference between “Traditional Finance” and “Behavioral Finance” are as follows:

  • Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioral finance recognizes that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their belief and predisposes them to commit errors.
  • Traditional Finance presupposes that people view all decision through the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioral finance postulates that perceptions of risk and return are significantly influenced by how decision problem is framed. In other words, behavioral finance assumes frame dependence.
  • Traditional finance assumes that people are guided by reasons and logic and independent judgment. While, behavioral finance, recognizes that emotions and herd instincts play an important role in influencing decisions.
  • Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioral finance contends that heuristic-driven biases and errors, frame dependence, and effects emotions and social influence often lead to discrepancy between market price and fundamental value.
  • EMH views that price follow random walk, though prices fluctuate to extremes, they are brought back to equilibrium in time. While behavioral finance views that prices are pushed by investors to unsustainable levels in both direction. Investor optimists are disappointed and pessimists are surprised. Stock prices are future estimates, a forecast of what investors expect tomorrow’s price to be, rather than an estimate of the present value of future payment streams.

Behavioral finance questions whether the behavioral assumptions underlying the EMH are true. Another aspect of behavioral finance concerns how investors form expectations regarding the future and how these expectations are transformed into security prices. By considering that investors may not always act in wealth maximizing manner and that investors may have biased expectations.

Characteristics of Behavioral Finance

Four Key Themes- Heuristics, Framing, Emotions and Market Impact characterized the Behavioral finance area.

  1. Heuristics: Heuristics are referred as rule of thumb, which applies in decision making to reduce the cognitive resources to solve a problem. These are mental shortcuts that simplify the complex methods to make a judgment. Investor as a decision maker confronts a set of choices within certainty and limited ability to quantify results. This leads identification and understanding of all heuristics that affect financial decision making. Some of heuristics are representativeness, anchoring & adjustments, familiarity, overconfidence, regret aversion, conservatism, mental accounting, availability, ambiguity aversion and effect. Heuristics help to make decision.
  2. Framing: The perceptions of choices that people have are strongly influenced by how these choices are framed. It means choices depend on how question is framed, even though the objective facts remain constant. Psychologists refer this behavior as a ‘frame dependence’. Investors forecast of the stock market depends on whether they are given and asked to forecast future prices or future return. So it is how framing has adversely affected people’s choices.
  3. Emotions: Emotions and associated human unconscious needs, fantasies, and fears drive much decision of human beings. How these needs, fantasies, and fears influence financial decision? Behavioral finance recognize the role Keynes’s “animal spirit” (The term animal spirit was innovated by John Maynard Keynes and it indicate the internal urge for action by business people and consumers to engage in more investment and consumption. Hence animal spirit is the psychological urge to get into more economic activities by investors and consumers. Keynes explains the concept in this book General Theory: “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction.”) plays in explaining investor choices, and thus shaping financial markets. Underlying premises is that our feeling determine psychic reality affect investment judgment.
  4. Market Impact: Do the Cognitive errors and biases of individuals and groups of people affect market and market prices? Indeed, main attraction of behavioral finance field was that market prices did not appear to be fair. How market anomalies fed an interest in the possibility that they could be explained by psychology? Standard finance argues that investors’ mistakes would not affect market prices because when prices deviate from fundamental value, rational investor would exploit the mispricing for their own profit. But who are those who keep the market efficient? Even institutional investor exhibits the inefficiency. And other limit to this is arbitrage. This prevents rational investor from correcting price deviations from fundamental value. This leaves open the possibility that correlated cognitive errors of investor could affect market prices.


Because of the many flaws of accepted economic theory, behavioral finance serves as a good complement. The assumptions of perfectly rational individuals and perfect information seem to work in some situations. Behavioral finance then gives explanations as to why the market behaves as it does.

Most of people know that emotions affect investment decisions. People in the world of investments commonly talk about the role that greed and fear play in driving stock markets. Behavioral finance extends this analysis to the role of biases in decision making, such as the use of simple rules of thumb for making complex investment decisions. In short Behavioral finance uses psychology to explain this behavioral decision making.

Behavioral finance takes a different approach, through recognizing the cognitive errors and emotions, human being is prone to while making financial decisions. It is an attempt to describe human behavior positively, to understand how people behave in financial settings. This helps to understand, psychological influences market behavior when investor perception influence markets and how the market action influence investors perception.

Thus, behavioral finance can be presented as the field which combines behavioral and cognitive psychological theory with conventional economics and finance to provide explanation for why people/investors make irrational choices or irrational financial decisions. Behavioral finance could be most interesting in the academic world for the time being.

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