Behavioral Finance

Behavioral finance talks about the psychological influencers and biases affect the financial behaviors of investors and financial practitioners. These influences and biases can be the source for explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price. The purpose of the classification of behavioral finance is to help understand why people make certain financial choices and how those choices can affect markets. Stock market returns are one area of finance where psychological behaviors are often assumed to influence market outcomes and returns but there are also many different angles for observation. One of the key aspects when it comes to behavioral finance studies is the influence of biases. There are many types of biases such as confirmation bias, experiential bias, loss aversion and familiarity bias. Understanding and classifying different types of behavioral finance biases can be very important when narrowing in on the study or analysis of industry or sector outcomes and results.

Concepts of Behavioral finance:-

  1. Herd Behavior: People tend to mimic the financial behaviors of the majority of the herd. The herd mentality is notorious in the stock market as the cause behind dramatic large scale purchases and sell-offs.
  2. Anchoring: Anchoring refers to attaching a spending level to a certain budget or reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction levels gained.
  3. Emotional Gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Emotions are often a key reason why people do not make rational choices.
  4. Mental Accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes.
  5. Self-attribution: It refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution usually stems from a flair one may have in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when in reality, it may not be correct or enough.

The applications of behavioral science to finance are now broad and well researched. They encompass activities such as spending, investing, trading, financial planning, portfolio management and business commerce. It also provides a blueprint to help us make better, more rational decisions when it comes to financial matters. Behavioral finance is still young and is only now beginning to make its way into mainstream academics, industries and society.

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