What is Behavioral Finance?

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During the 1990s, a new field known as behavioral finance began to emerge in many academic journals, business publications, and even local newspapers. The foundations of behavioral finance, however, can be traced back over 150 years. Several original books written in the 1800s and early 1900s marked the beginning of the behavioral finance school. Originally published in 1841, MacKay’s Extraordinary Popular Delusions And The Madness Of Crowds presents a chronological timeline of the various panics and schemes throughout history. This work shows how group behavior applies to the financial markets of today. Le Bon’s important work, The Crowd: A Study Of The Popular Mind, discusses the role of “crowds ” (also known as crowd psychology) and group behavior as they apply to the fields of behavioral finance, social
psychology, sociology, and history. Selden’s 1912 book Psychology Of The Stock Market was one of the first to apply the field of psychology directly to the stock market. This classic discusses the emotional and psychological forces at work on investors and traders in the financial markets. These three works along with several others form the foundation of applying psychology and sociology to the field of finance. Today, there is an abundant supply of literature including the phrases “psychology of investing” and “psychology of finance” so it is evident that the search continues to find the proper balance of traditional finance, behavioral finance, behavioral economics, psychology, and sociology.

The uniqueness of behavioral finance is its integration and foundation of many different schools of thought and fields. Scholars, theorists, and practitioners of behavioral finance have backgrounds from a wide range of disciplines. The foundation of behavioral finance is an area based on an interdisciplinary approach including scholars from the social sciences and business schools. From the liberal arts perspective, this includes the fields of psychology, sociology, anthropology, economics and behavioral economics. On the business administration side, this covers areas such as management, marketing, finance, technology and accounting.

This paper will provide a general overview of the area of behavioral finance along with some major themes and concepts. In addition, this paper will make a preliminary attempt to assist individuals to answer the following two questions: How Can Investors Take Into Account the Biases Inherent in the Rules of Thumb They Often Find Themselves Using? How Can Investors “know themselves better” so They Can Develop Better Rules of Thumb? In effect, the main purpose of these two questions is to provide a starting point to assist investors to develop their “own tools” (trading strategy and investment philosophy) by using the concepts of behavioral finance.

What is Standard Finance?

Current accepted theories in academic finance are referred to as standard or traditional finance. The foundation of standard finance is associated with the modern portfolio theory and the efficient market hypothesis. In 1952, Harry Markowitz created modern portfolio theory while a doctoral candidate at the University of Chicago. Modern Portfolio Theory (MPT) is a stock or portfolio’s expected return, standard deviation, and its correlation with the other stocks or mutual funds held within the portfolio. With these three concepts, an efficient portfolio can be created for any group of stocks or bonds. An efficient portfolio is a group of stocks that has the maximum (highest) expected return given the amount of risk assumed, or, on the contrary, contains the lowest possible risk for a given expected return.

Another main theme in standard finance is known as the Efficient Market Hypothesis (EMH). The efficient market hypothesis states the premise that all information has already been reflected in a security’s price or market value, and that the current price the stock or bond is trading for today is its fair value.

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