Introduction
Decisions about money are made solely on the basis of careful analysis and logic. People want to believe that when it comes to their financial lives, they are weighing risks, calculating returns, and making decisions that are in their best financial interest. In reality, however, money management is influenced far more than we like to believe by our unconscious and often poor psychological and emotional wiring. Behavioral finance, a relatively new and expanding field of study on finance, is fundamentally based on this concept.
Understanding Behavioral Finance
For numerous years, long-established economic theories proposed that human beings behave in a rational manner and make determinations that serve to increase their monetary welfare. Nevertheless, the realities of financial markets and personal money management tell a contrasting tale. Not a few individuals make hasty, ill-considered choices motivated by fear, greed, or sheer overconfidence. As a result, these persons encounter severe difficulties in managing their finances. Silently, life does its part as a relentless teacher of tough lessons.
An instance of behavioral finance that exemplifies human actions is how we tend to fear losses much more than we prize gains of the same size.
The Role of Emotions
Powerful emotions influence financial behavior. People seem to behave better financially when they are in a good mood. Financial decisions made in an emotional state (good or bad) will have to consequence later. While making investment decisions fear and greed are two things most of the people has to face. Fear can lead to panic selling during a down market that locks in losses and pushes people onto the sidelines. Greed, conversely, leads to over-trading and taking on too much risk.
This emotional influence is not limited to investment decisions. It also affects our regular financial habits. That might not be a revelation for most of us, but it's a point emphasized in a recent report from the Stanford Center for Longevity and the investment firm T. Rowe Price. The authors not only describe the ways in which our emotions influence mundane financial decisions, but they also offer a sort of playbook for becoming more aware of our emotional states and for using that knowledge to make better decisions.
Psychological Patterns That Shape Financial Behavior
Besides emotions, money management is affected by a number of psychological biases. One of these is herd mentality, in which people behave like the crowd believing that what the majority is doing must to be correct. Bad judgments resulting from this can be panicked and selling at the bottom or purchasing at the top of a bubble. It can also result in wise choices, like purchasing cheap stocks against popular demand.
An investor's assessment of the value of a stock, for example, can be anchored to its starting price, therefore the investor would overlook dis-confirming data showing a notable shift in the market or company's performance.
Conclusion
Finance encompasses every aspect of decision-making with monetary implications. Yet humans are not always model decision makers. This dissertation seeks to explain our often strange and sub-optimal behavior with money. To do this, I explore three deviations from model behavior that have been discovered in the past few decades. The first deviation is from expected utility theory. As the psychologists Daniel Kahneman and Amos Tversky showed, people apparently think in wrong or strange ways when making decisions under risk and uncertainty.
