For a long time, the behaviors of finance practitioners were assumed to follow specific characters that were given in financial theories. As a result, forecasting of future events was done on assumption that human beings are rational and they operate in a specified way. However, it was discovered that investors exhibited characters that went against known theories. These behaviors were linked to human nature and therefore could be explained using social sciences. Consequently, another subject called behavioral finance was introduced.
Behavioral finance is a study of influence that psychological factors have on investors and managers regarding their financial decisions. It focuses on the relationship of social sciences, like sociology and psychology, with financial behaviors exhibited by financial practitioners (Bruce, 2010). Moreover, behavioral finance explains why markets are sometimes inefficient. In general, behavioral finance is used to explain outcomes of financial endeavors as well as peculiar actions of financial practitioners. Behavioral finance heavily uses theories of psychology to explain some financial phenomena. Psychology looks at financial practitioners as normal human beings who will take actions depending on their human nature. Accordingly, psychology is used in behavioral finance to explain that investors are normal and not rational as standard finance would take them to be. On the same note, behavioral finance explains reasons for trade and why people are more likely to invest in companies that are responsible socially among other behaviors.
Investors are affected by emotions and cognitive biases and have proved that they do not want more wealth per se. There are instances where investors have been seen preferring higher social status or more social responsibility as opposed to wealth, contrary to the belief of ration investors according to standard finance. As a result, behavioral finance uses psychological models to explain some behaviors. It should be noted that, behavioral finance has its roots from standard finance.
People have been known to behave in a rather funny way which is different from what ancient theories proposed. Overtime, people have been known to react at a rather spontaneous and high rate to some issues and not to others. For example, negative information about securities spreads slowly compared to positive news (Thaler, 2005). In this regard, behavioral finance observes varying behavior among decision makers overtime and hence comes up with possible explanation of how psychology influences decisions. Similarly, by studying psychology, finance practitioners are able to realize that there are other actions of human beings which are controlled by the subconscious and cannot therefore be explained by some laid down set of rules.
Psychological factors have been proved to highly affect investment decisions. Overconfidence is known to influence investment decisions, especially risk taking aspect. When investors are overconfident they make decisions thinking that they are correct, but sometimes they might be having wrong information (Thaler, 2005). It is important to note that overconfidence has been associated with excessive trading in the market. Generally, men are known to be overconfident than women. As a result, men are known to trade more than women. Unfortunately, excessive trading usually leads to reduced returns on investments and increased chances of suffering losses. Consequently, men investors averagely earn lower returns when trading compared to their women counterparts.
Similarly, many people fear making decisions that they will regret later. The fear of regret makes investors to postpone some crucial decisions even when no other factor can change their mind (Bruce, 2010). Cases have been reported where investors have held onto depreciating stocks for too long or sold appreciating stocks too fast because they fear regretting thereafter (Bruce, 2010). Furthermore, the human brain is psychologically known to use mental shortcuts in making decisions especially regarding complex issues, a process referred to as anchoring. In the case of anchoring, the additional information is modified to make decisions. As a result, investors make inconsistent decisions and sometimes peg their options on recent prices or earnings performance which can be misleading.
Additionally, the mind is known to assume that things with closely related qualities are similar. This quality of the mind causes generalization of investment opportunities as being either good or bad. Investors have been known to make decisions on whether to buy some stocks or not based on some few qualities and sometimes regret later, when it turns out that their decisions were wrong (Thaler, 2005). On the same note, a psychological factor known as myopic risk aversion where people seem to be shortsighted in their decisions is very influential in finance. These factor leads to investors using losses from a single investment venture as a yard stick of future opportunities and sometimes hold less than most favorable amount of stock.
It is important to note that human beings will always behave in a different way and no single mechanical theory can be used to understand them. Therefore, psychology will always play an important role in explaining human behavior and cannot be excluded from any decision making process. As a result, behavioral finance is a very important line of study in the current economic environment. It is through behavioral finance that the erratic behavior in investors and managers can be understood.
Bruce, B. (2010). Handbook of Behavioral finance. Northampton: Edward Elgar Publishing Inc.
Thaler, R. H. (2005). Advances in Behavioral Finance. Princeton: Princeton University Press.