What Is Behavioral Finance?

Traditional economic theories assume that people act rationally when making financial decisions. So, what is behavioral finance? It's an economic theory that explains often irrational financial behavior, such as overspending on credit cards or panic selling during a market downturn. People often make financial decisions based on emotions rather than rationality.¹

Behavioral finance uses financial psychology to analyze investors' actions. According to behavioral finance, investors aren’t rational. Instead, they have cognitive biases and limited self-control that cause errors in judgment.² Keep reading to explore more about behavioral finance principles.

The concept of behavioral finance dates to 1912 when George Seldon published “Psychology of the Stock Market.” However, the theory gained popularity and momentum in 1979 when Daniel Kahneman and Amos Tversky proposed that most investors tend to make decisions based on subjective reference points rather than objectively choosing the best option.³

A year later, Richard Thaler introduced the notion of “mental accounting,” which is the idea that people view their money differently based on its function, such as whether it’s for retirement or a college fund. Eventually, their work became the basis for the study of cognitive psychology and behavioral biases in finance, which features prominently in the field of behavioral finance.

According to behavioral finance theory, there are several types of cognitive biases that can affect an investor’s judgment. Being aware of the most common ones can help you avoid them in order to make more rational decisions.

Most people tend to overestimate their abilities in many areas. For instance, 65% of Americans think their intelligence is above average, and 73% think they’re better-than-average drivers.⁵

When you overestimate how much you know about the market or a specific stock, you’ll be tempted to make risky decisions like trying to time the market, which is trying to predict the best time to buy or sell stocks, or overinvesting in high-risk stocks, which are more likely to lose money.

Humans are social animals, so going along with the crowd is in our nature. From the hot new fashion trend everyone is wearing to the crowded restaurant that requires you to make reservations months in advance, people tend to make choices based on what others are doing.

In many situations, herd mentality is appropriate and benign—the only lasting harm is old pictures your children will mock (and eventually try to emulate). In financial markets, however, herd mentality can lead to asset bubbles, which is when the price of an asset like a stock rises rapidly but will eventually fall, and market crashes, which occur when a lot of investors sell off their stock.⁶

For example, the recent Silicon Valley Bank collapse was largely driven by social media rumors and ended up being the second-largest bank collapse in U.S. history.⁷

People feel the pain of a loss more acutely than the euphoria of a win, even if they win more than they lose. In financial terms, investors will often hold onto stocks they should sell to avoid realizing a loss. Conversely, they may sell too early to avoid further losses, when waiting for a market rebound would be the better option. Often investors with a strong loss aversion bias have portfolios that are too conservative, underperforming market norms.⁸

Confirmation bias explains how two people with opposing viewpoints can hear the same information, and each comes away believing it supports their opinion. When you have a firmly-held belief, you give heavier weight to evidence supporting your belief while minimizing evidence contradicting it.⁹

In finance, confirmation bias can lead you to overlook investment strategies or assets that fall outside of your bubble, causing you to miss significant growth opportunities. You may also invest too heavily in one area because you haven’t fully analyzed the risks.

While biases are a critical component in behavioral finance, there are other key elements in the theory, as well.

Heuristics is the process of simplifying a problem when you don’t have enough information to make a “perfect” decision. In these instances, you’re likely to use a shortcut or rule-of-thumb to make a decision that feels right. Heuristics simplify the decision-making process, which means they simplify the financial decision making process, as well. Without them, you'd have to spend much more time making decisions. However, relying on heuristics without carefully analyzing investment options can lead to irrational or incorrect decisions.¹⁰

In mental accounting, you place different values on money based on how you obtained it. If you buy a winning lottery ticket, for instance, you might blow it all on a spontaneous shopping spree even though you carefully budget your paycheck. This can lead to irrational financial decisions.¹¹

Anchoring is a type of heuristics that involves subconsciously using irrelevant information as a reference point. Historical values are common anchors. For example, if you bought a stock for $100 but it starts losing its value, you may be tempted to hold onto it because you don’t want to sell it for less.

Salespeople take advantage of anchoring by starting negotiations at far above market value. The inflated price serves as an anchor, so when they come down, it’ll seem like a good deal.¹²

Understanding behavioral finance can help you better serve your clients. Financial professionals who can use behavioral economics and finance to help their clients identify and overcome financial biases and mistaken heuristics will be in a position to provide more valuable advice. Additionally, experts in behavioral finance are viewed as thought leaders in the financial industry, which can further advance your career.¹³

While economic theory is rooted in numbers and formulas, people aren’t so easily constrained and categorized. Understanding what drives peoples’ behavior is essential for fully understanding any human endeavor, and finance is a uniquely human endeavor.

With William & Mary’s Online Master of Science in Finance, you’ll learn the skills you need to deliver contemporary solutions in a global financial environment. Our curriculum dives deep to prepare you for the challenges you’ll face as a C-suite leader in today’s evolving business landscape. From identifying value-creating opportunities to navigating risks and global challenges, you’ll gain the quantitative and leadership skills needed to launch or further a rewarding career in the financial industry. Contact an Admission Advisor for more information.