The Most Important Concepts of Behavioral Finance Theory – Backed By Science

The Most Important Concepts of Behavioral Finance Theory – Backed By Science

Do we understand our needs? Why is it so hard to make the right decision when it comes to purchases or financial flows? Does the right choice exist? Do basic or self-fulfillment needs drive us? If not behavioral finance theory could help you understand a lot of why you make decisions and whether they are rational.

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In a confusing modern financial world, there are a lot of issues to consider before investing money. The needs of investors are obvious but exactly what makes them think that some companies are worth investment, others aren’t? It is what specialists of behavioral finance theory are trying to find out.

behavioral finance theory

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The good news is that with the correct data and working algorithms which make precise predictions, it is possible to invest money with a low level of risk. Science backs these predictions.

Basic notions

Before going deep into the scientific background, let's define the these ideas. Behavioral finance is a use of psychology concepts for analysis of stock market anomalies and investments. Specialists are using behavioral and psychology finance economics in attempts to explain irregularities in the market like extreme price drops or increases in the market. It’s particularly important for investors and predicting their decisions.

The connection between study and investors

This study is connected to a decision-making process of investors. It is a complex combination of strategy, emotions, rationality, economy, and experience. There are two main aims of behavioral finance:

  • Finding out the process of learning of the personal mistakes of investors and creating a strategy
  • Exploring anomalies when investors are driven by emotions, passiveness, and other factors in decision-making.

Investors are in the center of the study of this complicated and hypothetical research, which involves psychology, economics, finance, data analysis, probability theory, and others.

Concepts of Behavioral Finance Theory in Simple Words

There is a study called market hypothesis. Many aspects of this study rely on the financial maturity of the participants. In other words, this is purely a theory where any action can be explained from the point of view of strategy, logic, knowledge, self-education, and the ability to learn from personal mistakes. Emotions are excluded. Many specialists are using data from these studies to predict market changes relying on future behavior similar to previous ones.

Rationality and irrationality

Participants in the stock market are human beings with emotions. Science and emotions have nothing in common, but in this case science ends the moment a participant is obligated to make a decision. This decision is the main point of interest for most Behavioral Finance Theory specialists. When it comes to the combination of money and prediction, it is much more than pure data. The fact that a person is obligated to make a decision allows the possibility of irrationality. Where is the edge between irrational and rational decision?

Emotions and finance

When talking about finances, emotions are the last thing that we associate them with. Finances are associated with responsibility, numbers, calculations, estimations, and pure math. This is only the tip of the iceberg. What if we think about money as possibilities they grant us with? Replace money in a financial market with fancy houses, expensive trips, business investments, or any other product or service and you will have an entirely different picture of the stock market. All the opportunities which money brings to people are connected with emotions. At this point, we can generalize the notion ‘finance' as emotions and numbers, which are a combination of rationality with irrationality. This is the answer to the previous question. The edge between irrational and rational decisions lies in the emotions.

Decision-making concept

The reasons which lead people to make certain decisions regarding their money is abstract data applied to the prediction of behavioral finance theory. According to marketers, every purchase is led by emotions. The choice of a certain product or service depends not on physical needs, but on moral ones. This change is driven by the overwhelming variety of products and services produced every day. It is reasonable to mention Maslow's hierarchy of needs. Most decisions in the financial world are driven by self-fulfillment needs to be at the top of the pyramid. This information can hardly be used by data scientists for prediction, but plays a valuable role in the stock market.

Data science in behavioral finance

This study is trying to combine rational theory, mentioned before with the irrational aspect of making decisions that involves emotions, among many other factors. It is a complicated study, which gives investors more precise predictions. Behavioral finance is a field where data scientists are doing their best job in attempts to combine rational and irrational data and provide the most reasonable prediction for those investors who want to invest wisely. The results of such prediction may lead to a regular income and success in the stock market.

Bubbles and panics

A ‘Bubble’ in the financial world is a concept that means artificially inflated prices, which eventually will drop to realistic ones. The best example of a bubble in a world market is the dot-com price during 1995 and early 2000. Investors believed that dotcoms, any online company with .com, would eventually profit and inevitably bring a significant income. This was later called overconfidence. On March 10, 2000, when the dotcoms' market had reached its peak, a few leading companies like Cisco and Dell decided to sell their stock. Within a month, all investors became holders of worthless shares.

The concept

With modern science in many fields including artificial intelligence, specialists are trying to use as much data as possible to predict the most unexpected reactions, like bubbles and panics. On their way to success, they have reached some of their goals, but there is a lot of work to do and a lot of science to apply. With the growing of innovation systems that can teach themselves much more efficiently than human beings, it might be possible to provide investors with the most precise predictions and minimum risks. It will not only provide them with a stable income, but also change the behavior by minimizing irrational decisions. This is how a perfect stock market looks.


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