Investors Behaving Badly?

March 28, 2005 • Posted in Animal Spirits

“[B]ehavioral finance attempts to explain and increase understanding of the reasoning patterns of investors, including the emotional processes involved and the degree to which they influence the decision-making process. Essentially, behavioral finance attempts to explain the what, why, and how of finance and investing, from a human perspective.” In his March 2005 paper entitled “A Research Starting Point for the New Scholar: A Unique Perspective of Behavioral Finance,” Victor Ricciardi provides a brief history and overview of behavioral finance. He notes that:

  • Behavioral finance investigates the cognitive biases (misorganization of information) and the emotional aspects of the decision-making processes of novice and expert investors.
  • Central to behavioral finance is prospect theory, which holds that: investors are more concerned with losses than by gains, assigning more significance to avoiding loss than to achieving gain (loss aversion); individuals are concerned more with changes in wealth than adjustments in levels of wealth; and, people overweight small probabilities and underweight middle range probabilities.
  • Another important behavioral finance concept is bounded rationality, which assumes that human rationality has limitations, especially under conditions of substantial risk and uncertainty.
  • Behavioral finance is interdisciplinary, as illustrated by the chart below.

The author lists the following topics/terms as important to behavioral finance:

In summary, behavioral finance adds elements of human irrationality to the standard finance foundation concepts of Modern Portfolio Theory and Efficient Markets Hypothesis.

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