Behavioral Finance: Psychology of Financial Decision-Making

Behavioral finance theory is the study of how psychological and emotional factors influence our decision-making. Traditional finance theory is based on the concept that investors are rational. They are not clouded by cognitive errors and use the relevant data to make informed decisions. The approach of behavioral finance is very much the opposite. It suggests that, as humans, we have inherent flaws. We don’t always act rationally, and we have limits to our self-control. Instead, emotions, cognitive errors and biases can often influence our choices. Behavioral finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on market. According to behavioral finance, investors’ market behaviour derives from psychological principles of decision-making to explain why people buy or sell stock. Behavioral finance focuses upon how investor interprets and acts on information to take various investment decisions. In addition, behavioral finance also places emphasis on investor’s behaviour leading to various market anomalies. Behavioral Finance (BF) is the study of investors’ psychology while making financial decisions. Investors fall prey to their own and sometimes others’ mistakes due to use of emotions in financial decision-making. For many financial advisors BF is still an unfamiliar and unused subject. Its prominence was reflected when traditional finance theories failed to explain many economic events like stock market bubbles in the United States. The two main ingredients of the study are cognitive psychology describing how people behave and the limits to arbitrage, explaining the level of effectiveness or ineffectiveness of arbitrage forces in various circumstances. We make thousands of decisions every day. We usually make these decisions with almost no thought, using what psychologists call “heuristics” – rules of thumb that enable us to navigate our lives. Without these mental shortcuts, we would be paralyzed by the multitude of daily choices. But in certain circumstances, these shortcuts lead to errors. Behavioral finance is the study of these and dozens of other financial decision-making errors that can be avoided, if we are familiar with the biases that cause them. In this course, we examine these predictable errors, and discover where we are most susceptible to them. This course is intended to guide participants towards better financial choices. Learn how to improve your spending, saving, and investing decisions for the future.