Why do investors sometimes act irrationally and make decisions based on emotions rather than facts?
Behavioral finance is an aspect of financial markets worth exploring. Most investors believe they make rational decisions, yet, in reality, this is often not the case. A wide range of biases can influence decision-making, even if the investor is unaware of it. Understanding the financial psychology that drives asset pricing can also be beneficial for investment planning and risk management.
What is behavioral finance?
Investment theories tend to assume that people make rational decisions. The reality, however, often differs significantly, as emotions, biases, social factors, and cognitive errors play a considerable role in decision-making. Behavioral finance is a field that considers the decision-making processes of ordinary, rather than rational, individuals. This area is gaining increasing importance as a crucial aspect of financial analysis.
Much of the financial theory developed over the past seven decades views investors as rational beings. This aligns with the broader field of economics, which also considers decision-makers as rational. Modern portfolio theory and the efficient market hypothesis are two of the most cited theories in traditional investing.
Both theories make several assumptions regarding investment decision-making. These include the assumption that investors seek to maximize profits and that they act rationally. Behavioral investing theory investigates the fact that investors are often not rational. It also considers the various motivations behind investors' decision-making. To some extent, this explains certain anomalies between financial models and actual outcomes.
A thorough understanding of financial psychology can help investors recognize some shortcomings of traditional finance. It also enhances awareness of cognitive biases and mistakes they may make as investors. In the realm of quantitative investing, efforts are being made to incorporate real-world outcomes rather than mere theoretical frameworks into decision-making.
