16.1 : An Overview of Behavioral Finance

Behavioral finance integrates psychology with financial theory to explain why investors deviate from rational decision-making. Unlike traditional finance, which assumes logical decision-making, behavioral finance highlights cognitive biases, heuristics, emotions, and social influences.

Heuristics and Biases

Heuristics or mental shortcuts aid decision-making but can cause errors. Overconfidence makes investors overestimate their knowledge, resulting in excessive trading and suboptimal choices. Anchoring causes investors to rely on initial information, such as a stock’s past price, which affects their decisions. The availability heuristic makes recent information overly influential in decision-making, often disregarding fundamental analysis.

Cognitive biases further distort rational thinking. Confirmation bias leads investors to favor information that supports their preexisting beliefs, reinforcing poor decisions. As prospect theory describes, loss aversion causes people to fear losses more than they value gains, making them reluctant to sell loss-making investments.

Framing Effect and Emotions

Framing affects decisions based on how information is presented. Investors prefer options framed as gains rather than losses, even when financial facts remain identical. For example, a 70 percent success rate appears more favorable than a 30 percent failure rate.

Emotions significantly impact market behavior. Excessive optimism and herd mentality fueled the dot-com bubble, while fear drove panic selling during crashes. Recognizing these tendencies helps investors make informed choices and improve financial outcomes.