Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. Behavioral finance is of interest to value investors because it helps explain why and how markets might be inefficient. In addition, the study of behavioral finance helps investors understand how the mind can help or hinder investment success.
Many behavioral biases are ingrained aspects of human decision-making processes, which have served us well as ways of coping with day-to-day choices. But, are unhelpful for achieving success in long-term activities such as investing.
Only by understanding the biases and their effect, are we able to avoid major pitfalls and achieve a better understanding of financial market behavior.
“Traditional vs. behavioral finance
Over the past fifty years established finance theory has assumed that investors have little difficulty making financial decisions and are well-informed, careful and consistent. The traditional theory holds that investors are not confused by how information is presented to them and not swayed by their emotions. But clearly reality does not match these assumptions.
Behavioral finance has been growing over the last twenty years specifically because of the observation that investors rarely behave according to the assumptions made in traditional finance theory.
Behavioral researchers have taken the view that finance theory should take account of observed human behavior. They use research from psychology to develop an understanding of financial decision making and create the discipline of behavioral finance. This guide summarizes the findings of these ground-breaking financial theorists and researchers.”
“We cannot cure the biases, but we can attempt to mitigate their effects. Using techniques such as feedback, audit trails for decisions, checklists, and ‘devil’s advocates’ can help us take decisions in a more rational manner and improve the chances of investment success.”
“Understanding our brains
One emerging strand of research is the field of neuroeconomics. Medical imaging technology now allows us to look at brain activity as decisions are being made. This helps us to understand the nature and reasons for certain behavioral biases. A recent study demonstrated that individuals with brain lesions that impaired emotional decision-making were more likely to behave as rational investors than individuals with normal brains. (Source.) Other imaging studies have confirmed that the rational parts of our brain are in tension with the emotional or limbic sections of our brain. This line of enquiry offers the possibility of understanding and improving decision making.”