The Role of Behavioral Finance: Investor Psychology, Market Anomalies and Decision-Making

People often think of economics as a rational field, but emotions play a bigger role than you might think. Behavioral finance, the study of how psychology influences financial decisions, can tell us a lot about economic trends and individual choices.

So what is behavioral finance, exactly? And how do psychology and decision-making intersect? This article will break down the key impact of behavioral finance on investor psychology, market anomalies and decision-making in finance.

Behavioral finance is a subfield of behavioral economics or the study of irrational behavior in financial decision-making. Studying behavioral economics is one way to explain why economic systems don’t always work the way you might expect them to. In other words, markets are often irrational because they’re driven by people who make irrational decisions.

The key to understanding behavioral finance, or behavioral economics, is understanding how psychological biases can affect the decision-making process around finances. Those biases include:¹

• Confirmation bias: People tend to believe statements that align with their current beliefs
• Repetition bias: Frequently repeated statements often seem more credible
• Risk aversion: People are more likely to make a low-risk decision over a high-risk decision
• Herd effect: The herd effect is the inclination to follow the crowd or do what’s popular

These biases apply to everyday decisions, such as choosing where to have lunch or sharing a social media post, but they also impact financial decision-making.

Traditional finance theory relies on rational choice theory: The idea that individuals will always make decisions that align with their best interests.² Behavioral finance, on the other hand, seeks to understand why people might make choices that don’t ultimately serve them. This offers a more nuanced view of economics and can explain flaws and anomalies that traditional finance theory doesn’t account for.

People don’t always act rationally, and investors are no different. That’s why understanding behavioral finance concepts is one of the most important soft skills in finance.

You don’t have to be an expert in psychology to make smart investments. However, understanding the relationship between investor psychology and market trends can help you make educated predictions about future performance, address your own biases and invest wisely.

Emotions and cognitive biases play a role in even a well-educated investor’s choices. That includes the biases listed above, as well as external factors such as cultural influences, which can impact an investor’s sense of loss aversion and patience.³ The herd effect is a particularly important concept in investor psychology—trading an asset simply because it’s viewed as a hot commodity can lead to asset bubbles and have a large-scale impact on the wider market.⁴

Can behavioral finance explain major stock market anomalies in finance? Yes—and no. Like any field, behavioral finance is not a perfect science, and it can’t always predict a market anomaly before it happens. However, you can look back at financial events through a behavioral lens in order to better understand what happened.

Remember that the herd effect can lead to market bubbles and crashes. For example, consider the dot-com bubble of the late 1990s, in which a frenzy over the internet led to an over-investment in unprofitable companies.⁵ Psychological theories can also explain anomalies in asset pricing, such as the GameStop phenomenon of 2020, in which a small group of investors drove up the price of GameStop’s stock during the COVID-19 lockdowns.⁶

Behavioral finance and market decisions aren’t always easy to understand. However, an understanding of psychology can help everyday investors make sense of seemingly random events.

You may have heard of the five principles of finance, which can improve your financial literacy. When it comes to behavioral finance, however, there are a few more advanced theories that can help improve your decision-making.

Prospect theory is one example. This theory aims to predict how people will assess risk based on expected outcomes rather than absolute outcomes.⁷ Prospect theory can be used to support predictive market models and to address one’s own biases as an individual investor. Heuristics—the process of simplifying complex decisions—and biases should also be addressed in investment decision-making.

Some helpful strategies for overcoming your own biases and cognitive limitations in investing include:

• Discussing investment decisions with multiple unrelated advisors
• Avoiding impulsive decisions, especially when influenced by trends
• Assessing your financial position before making a decision
• Investing in a diverse portfolio to offset potentially risky decisions
• Getting an education in behavioral finance and investing

Aside from informing individual investment decisions, how does the study of behavioral finance apply in real life?

For one thing, behavioral finance plays a role in large-scale investment management. Finance professionals who manage large investment portfolios will benefit from a thorough, up-to-date education in behavioral finance.

Another example is behavioral bias in retirement savings. Research in behavioral finance has significantly impacted retirement savings, highlighting how inertia and loss aversion influence retirement planning. Studies have shown that automatically enrolling employees in retirement savings plans increases participation rates, as many individuals exhibit status quo bias and would not opt-in on their own.⁸ Similarly, adjustments in the default contribution rates can counteract loss aversion, as individuals tend to stick with default settings even if they are suboptimal.

A behavioral finance education can also support a successful career in financial advising—helping individuals mitigate their biases and make smarter, well-informed investments.

Behavioral finance is an ever-evolving field that supports a number of financial careers. If you’re interested in learning more about the challenges, theories and strategies of this field, consider an Online Master of Science in Finance (MSF) degree from William & Mary.

With a fully online education, you’ll have the opportunity to get educated and boost your career without taking time away from your work and family. And, when you choose William & Mary’s Online MSF program, you have the unique opportunity to graduate with both your master’s degree and a specialized finance certificate—either a Corporate Finance certificate or an Investment Management certificate—in as few as 16 months. Earn two credentials and get a deep dive into finance more quickly and thoroughly than you would with a typical MBA.

Speak to an admissions outreach advisor today to learn more about the benefits of the Online MSF.