Behavioral Finance Research Paper Starter

Behavioral Finance

(Research Starters)

This article focuses on behavioral finance. It provides an overview of the history of behavioral finance. The relationship and debate between behavioral finance and neoclassical economic theory is addressed. The topics of investor bias, efficient markets, rational investors, risk attitudes, mental accounting, and investor overconfidence are explored. The issues associated with using behavioral finance to identify investor bias are discussed.

Keywords Asset Allocation; Behavioral Finance; Bias; Cognitive Science; Dividends; Efficient Market Hypothesis; Efficient Markets; Equity Premium Puzzle; Heuristics; Investor Bias; Mental Accounting; Neoclassical Economic Theory; Neoclassical Economics; Neuro-economics; Portfolio; Prospect Theory; Psychology; Rational Investors; Risk Attitudes

Finance: Behavioral Finance


Behavioral finance, also referred to as behavioral economics, combines economics and psychology to analyze how and why investors make their financial decisions. The field of behavioral finance, which has much in common with the field of cognitive psychology, offers a theoretical explanation for the sometimes irrational or emotional choices and actions of investors (Salsbury, 2004). Despite the supposition of neoclassical economics that the market is efficient and that investors are rational, investing behavior and market behavior can be wildly irrational and inconsistent. As a result of the psychology of individual investors, stocks may be mispriced and markets may be inefficient. Behavioral economics offers an explanation for economic irrationality and economic anomalies in the market as well as a strategy for capitalizing on the unique psychology and decision-making processes of individual investors. Behavioral finance, which originated in the 1970s, gained prominence and legitimacy in 2002 when psychologist Daniel Kahneman won the Nobel Prize in economics for his work in the field of behavioral economics.

Behavioral economics incorporates data and theories about investors' cognitive ability, social interaction, moral motivation, and emotional responses into economic modeling to better understand economic outcomes. Behavioral finance recognizes that individuals, including professional investors, use heuristics to make investment decisions. Heuristics, which refer to the use of experience and practical efforts to answer questions or to improve performance, are a form of selective interpretation of information. The use of heuristics, by definition, leads to incomplete information in the decision-making process (Fromlet, 2001). Behavioral finance finds that the following variables affect economic decision-making: Biases, self-control, mental accounting, savings, fairness, altruism, public good, learning, incentives, memory, attention and categorization.

Behavioral finance is an academic field and a portfolio management approach (Stewart, 2006). Financial analysts use behavioral finance to augment or supplement classical and neoclassical financial theory and approaches. The psychological factors that have long been excluded from conventional financial analysis do affect market outcomes (Fromlet, 2001). While behavioral-finance guided investing, also referred to as behavioral investing, has not eclipsed traditional modern portfolio theory, behavioral investing has established itself as a legitimate investment technique or strategy. In particular, behavioral-finance guided investing has grown in favor following the drop in technology stocks in 2000. Behavioral investors use their understanding of human psychology to find underpriced or overpriced stocks to purchase or sell. Mispriced securities have the potential to be lucrative for savvy investors (Singh, 2005).

Ultimately, behavioral finance argues that financial decision-making is influenced by individual and market psychology. Behavioral finance addresses the following issues and questions (Taffler, 2002):

  • What causes stock market bubbles?
  • Why is the stock market so volatile?
  • Why are under and overvalued stocks difficult to identify?
  • Why do stock prices appear to under react to bad news?
  • Why do most boards of directors often believe their companies are undervalued by the stock market?

The field of behavioral finance characterizes investors in the following ways: Investors are often biased in their economic decision-making; investors are known to be overly-optimistic of investment decisions; investors are known to overestimate the chances of their success; and investors are known to overestimate their financial knowledge (Litner, 1998). Behavioral finance operates to create theoretical insight about investor behavior and create a system for more accurate predictions of investors' behavior.

The following sections provide an overview of the history of behavioral finance. This overview will serve as a foundation for later discussion of behavioral finance and the challenge to neoclassical economic theory. The issues associated with using behavioral finance to identify investor bias are addressed.

The History of Behavioral Finance

The academic field of behavioral finance began in 1979 when psychologists Daniel Kahneman and Amos Tversky introduced prospect theory. Prospect theory introduced a rubric for understanding how the framing of risk influences economic decision-making. Amos Tversky and Daniel Kahneman developed the field of behavioral finance through their work on the psychology of risk. Their work, and behavioral economics in general, challenges the basic assumptions of rationality inherent in the classical economic model of decision-making. Tversky and Kahneman studied three main areas: Risk attitudes, mental accounting, and overconfidence (Litner, 1998).

  • Risk attitudes: While classical economic theory argues that investors are averse to risk, behavioral finance holds that investors exhibit inconsistent and often conflicting attitudes toward and about financial risk. Tversky and Kahneman found that investors have an individualized reference point for risk and will be most sensitive to risk when that reference point is reached.
  • Mental accounting: While classical economic theory argues that money is fungible and interchangeable, behavioral finance holds that money is not completely fungible for most people. Tversky & Kahneman developed the idea of individualized mental accounts to explain why money is not wholly fungible for most people. Mental accounts, a wholly intangible form of accounting, contain financial resources that for personal and often irrational reasons are not easily transferred.
  • Overconfidence: While classical economic theory argues that investors are rational decision makers who use the financial information that is available to them, behavioral finance holds that investors are prone to overconfidence and biased decisions. Tversky & Kahneman found that investors were often overly optimistic about investment decisions, overestimated the chances of financial success, and overestimated their financial knowledge.

In 2002, Daniel Kahneman received the Nobel Prize in economics. Richard Thaler was another important early contributor to the field of behavioral finance. Richard Thaler, in the 1980s, extended the scope of behavioral finance by making stronger connections between psychological and economics principles (Lambert, 2006). The field of behavioral finance has grown over the last three decades in large part as a result of the support that the field received from universities and research institutions.

The Russell Sage Foundation

One of the largest non-profit supporters of the behavioral finance, or behavioral economics, field is the Russell Sage Foundation. The Russell Sage Foundation provides academics and finance professionals interested in the behavioral finance field with significant research and development support. The Russell Sage Foundation began its Behavioral Economics Program in 1986 with the stated goal of “strengthening the accuracy and empirical reach of economic theory by incorporating information from related social science disciplines such as psychology and sociology.” The Russell Sage Foundation's Behavioral Economics Program established itself at the intersection between economics and cognitive psychology and dedicated the program's resources to understanding how the real-world economic decisions of investors often contradict the rational standards in...

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