Why even the best Wall Street investors make mistakes? Aren’t they calculating risks before making their investment? They may have accurate information, know the right timing, and advanced technology to lead to successful investment. However, those investors do make mistakes.
The reasons for such mistakes are due to financial practitioners’ bias, over-confidence, and emotion misguiding their financial judgment. This gave a rise to the appearance of ‘behavioral finance.’ It seeks to combine behavioral and psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
Then what is conventional financial theory? That is, assuming that economic participants are, for the most part, rational ‘wealth-maximizers.’ This is fundamentally based on the efficient market hypothesis, which does not account for irrationality of individuals. There are some critics of behavioral finance, arguing that findings in behavioral finance are just a collection of anomalies.
However, there are so many instances where emotion and psychology influence financial/economic decision making, causing individuals to behave in unpredictable or irrational ways. The interpretation of behavioral finance is well addressed in the book, ‘Beyond Greed and Fear’ by Hersh Shefrin.
The author uses the findings of psychological research to depict how human behavior guides stock selection, financial services, and corporate financial strategy. Those findings indicate the investment pitfalls caused by human error, which cannot be explained if individuals are seeking profit-maximization only.
It does not matter whether you are a supporter of efficient market hypothesis or not. Whatever your perspective is to view finance, wouldn’t it be great to have a look at newly emerging insight? This is another way of analyze finance, and more specifically, ‘how individuals behave and react’. Understanding behavioral finance may allow you to recognize, and hopefully avoid, bias and errors in financial decisions.