Behavioral Finance - Darren Winters

Psychologists have known for a long time that people often act in a seemingly irrational manner and make predictable errors when forecasting. This behavior is harmless when it causes a zest for the home sports team. Being overly optimistic when rooting for your team is fun. However, when this behavior affects your investing decisions, it can cause you to make small mistakes that lower your return or make big blunders that devastate your wealth.

All people are affected by psychological biases. However, traditional finance considers this irrelevant. Traditional finance assumes that people are "rational." Financial theory has developed with the proposition, called market efficiency, that stock prices are reasonably accurate and reflect the true value of firms. If stock prices are efficient, then investors won't do serious harm to their wealth if they trade frequently or follow specific investing strategies. Therefore, financial economics has developed in a proscriptive manner. That is, it has developed ideas and useful financial tools for how investors should behave. As a consequence, little research has been conducted on actual investor behavior.

Alternatively, behavioral finance examines how people actually behave in a financial setting. Specifically, it is the study of how psychology and emotions affect financial decisions and financial markets. If the psychology of investors, as a group, is strong enough, it may affect the accuracy of stock prices. Indeed, stock market manias and bubbles may result. Additionally, by allowing psychological bias and emotion to affect their investment decisions, investors can do serious harm to their wealth.

Behavioral finance is a relatively new field and is developing rapidly. In my book Investment Madness, I documented many of the known problems with letting psychological biases invade the decision-making process. As more scholars and investment professionals have become interested in behavioral finance, the theories have evolved and evidence for their validity has expanded. In this chapter, I review many of these psychological biases and emotions that cause investors to make mistakes. The problems are illustrated here with new evidence and recent examples.

I organize these investment problems into three categories: psychological biases, emotions, and simplification. Specific problems within each category are detailed in the following three sections.

Thanks Darren Winters