Behavioral Biases In Financial Decision-Making

Geetika Madaan Sukheja Sr.

Chandigarh University, Students

April 5, 2016


Behavioral finance is an emerging field of study which is relatively new and having its provenance from decision theory. Behavioral finance is a multidisciplinary research area that combines psychology and finance and investigates the issues that impact the decision-making process and explains the irrational nature of individuals, groups and organizations. Behavioral finance tries to address those psychological traps that are confronted while making decisions under uncertainty. The main objective of this study is to explore behavioral determinants influencing individual investor’s decision at financial front. The paper tries to extend the knowledge of how biases, moods and emotions influence the financial behavior of individuals. In conclusion, the paper will provide future paradigm of behavioral finance.

Behavioral Biases In Financial Decision-Making – Introduction

Over the past fifty years, conventional finance theory has assumed that investors have little difficulty in making financial decisions and investors are well-informed about prices and they are judicious and persistent. The conventional theory holds that investors are not baffled by how information is presented to them and not swayed by their emotions (Byrne, 2013). But clearly its perceptibility does not match with these conjectures. Behavioral finance has been growing over the last twenty years because of its cognizance that investors rarely behave according to the conjectures made in conventional theory of finance. Behavioral researchers have the view that finance theory should take account of observed human behavior (Utkus, 2013). They use research from the field of psychology to establish an understanding of financial decision-making under unpredictability and develop the regimen of behavioral finance.

Provenance and growth of Financial economics, the flux of international markets, and the operation of abettors therein (individuals as well as firms), are topics which are ultimately peruse differently by people. Over the past 20 years, so many debates have been on-going between ‘rationalists’ who assume that pecuniary abettor behave rationally, against ‘behaviourists’, who consider that they behave in systematically irrational ways (MC Guckian,2013). There is a certainly plethora of alternative opinions, advocating psychologically realistic stance in economics and at present we are in a conversion phase between two paradigms (Stiglitz, 2010). Theories developed by researchers in classical finance tend to accept that investors only evaluate risk and expected returns when making investment decisions. Indeed, staple approaches in financial economics base certain assumptions about abettors’ psychology, and typically this has been considered as a great brawniness. In the field of behavioral finance, the role of human oversight in modeling markets is of significant importance, and it is felt that contemporary finance has ignored the importance of emotions and emphasize the rationality of decision making on mathematical models. The psychologists consider the rational model to be an impractical canon for human understanding. Psychologists believe that the terminology of behavioral finance is that it is centrally the pertinence of psychology to study human psychology in finance or investing – itself is an inflated expression; finance is intrinsically behavioral in nature. A wider range of components and instinctive elements, which are important to the financial decision making process of domiciliary and the cumulative inclination of financial markets, are taken into account by these psychologists.

Behavioral finance is akin to the terminology of ‘wet water’ – it is inherently known that the water is wet. This has mostly manifest because it is thought by many that evaluating real world economic behavior without including the findings of psychology is like dealing with quantitative relationships without using readily available techniques of mathematics (Schwartz, 2007). Keynes wrote about the impact of psychology in economics more than forty years ago. Furthermore, Paul Slovic professor of psychology propagated a detailed study of the investment mechanism from a behavioral point of view in 1969. However, in late 1980s that BF began to get acknowledgement among professionals. At that moment, Professors Richard Thaler at the University of Chicago, Robert Shiller at Yale University, Werner de Bondt at the University of Illinois, and Meir Statman and HershShefrin at Santa Clara University, among others, began to propagate research pertinent to Behavioral Finance (Olsen, 1998). These scholars began to explore a host of pragmatic findings that were not persistent with the view that market returns were set in consonance with the Capital Asset Pricing Model and the Efficient Market Hypothesis. Supporters of Traditional Finance regarded these decree as aberrant, and thus called them anomalies. Behavioral Finance main benefaction was to allow a better perceptive of the anomalies present in investors’ behavior by coordinating psychology with finance and psychology. However, it was not prior to Professor Daniel Kahneman of Princeton University was awarded in the year 2002 with Nobel Prize in economic sciences that Behavioral Finance gained propulsion. Thereupon, it was not prior to researchers initiated to discover pragmatic results that were not persistent with the efficient market theory that Behavioral Finance became popular.

Behavioral Biases

Behavioral Biases

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