Behavioral Finance

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Description of Behavioral Finance. Explanation.

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Behavioral Finance: Market EmotionsDefinition Behavioral Finance. Description.


Behavioral Finance (BF) is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on financial markets. The approach focuses on observable psychological factors that influence decision-making of financial decision makers.


Behavioral effects help explain why and how markets might be inefficient. Behavioral finance is contradicting the Efficient Market Hypothesis.


In 1912, G.C. Selden wrote "Psychology of the Stock Market: Human Impulses Lead To Speculative Disasters". He based the book "upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public".


In 1956, Leon Festinger introduced the theory of Cognitive Dissonance: in case two simultaneously held cognitions are inconsistent, people will have an uncomfortable feeling that leads towards attitude change in order to reestablish consonance.


In 1974, Amos Tversky and Daniel Kahneman described three heuristics that are employed when making judgments under uncertainty:

  • Representativeness: When people are asked to judge the probability that an object or event A belongs to class or process B, probabilities are evaluated
    by the degree to which A is representative of B, that is, by the degree to which A resembles B.
  • Availability: When people are asked to assess the frequency of a class or the probability of an event, they do so by the ease with which instances or occurrences can be brought to mind.
  • Anchoring and adjustment: In numerical prediction, when a relevant value (an anchor) is available, people make estimates by starting from an initial
    value (the anchor) that is adjusted to yield the final answer. The anchor may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient.

Behavioral finance applies scientific research on human and social Cognitive and Emotional Biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The behavioral finance field is primarily concerned with the lack of rationality of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.


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Full List of Cognitive Biases Classified into Four Different Areas

 

Efficient Markets and Behavioral Financial Decision Making

 

Giving Financial Advice on Dealing with Uncertainty

 

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Compare with: Cognitive Bias  |  Investor Sentiment  |  Short Selling  |  Analogical Strategic Reasoning  |  Bounded Rationality  |  Framing  |  Groupthink  |  Systemic Risk  |  Index Fund  |  Mutual Fund  |  Qualitative Investment Analysis  |  Whisper Number  |  Feedback Loops

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