Behavioral finance is a famous field of the finance that suggests the theories based on psychology (psychology finance or behavioral economics) in order to explain the concept of stock market anomalies which includes extreme rise and fall in the prices of stock market. The behavioral finance suggests that the structure of the information and characteristics of participants of the market plays an important role in the decision making of the investors as we as the overall outcome of the market.
Behavioral finance and investors:
Behavioral finance is more inclined towards the investors and their decision making for the following reasons:
- An individual who is capable of identifying the flaws in his behavior is capable of optimizing his decision and is wise enough to learn from his mistakes.
- Anomalies are extremely important part of the active management. Individuals, who believe in the fact that the markets are rational and the prices are inclusive of all type of information available, are capable of relying on the passive management.
Psychology Finance or the Brain and You!
The brain and its composition have been through a lot of evolution till date. The current composition is originated from the old times of the Stone Age when the basic needs were to hunt for survival. The needs of that time were different from the modern age. The current composition and its structure are not fit for modern age.
According to the Cerebral research, there are three centers inside the brain. All these center are developed and interact in a very different way.
- Limbic system, deals with the emotions.
- Cortex, deals with logics
- Recumbent part, deals with bodily functions.
Limbic is responsible for all types of emotions including excitement as well as fear. The limbic happens to be the oldest part. The emotions were part of the life before logic came in. This part of the brain works very quickly.
Cortex is basically responsible for all the learning, planning, logical thinking, calculating and making decisions. Cortex works slowly ad takes time to make a decision.
These two parts of the brain plays a very important role in the decision making. Both of the work in a very different way but they do function together.
Cortex and Limbic together form two types of systems. The behavioral patterns are basically controlled by these two systems:
- Loss prevention.
- Pursuit of reward
According to an old and exaggerated term used in the stock market: The entire market moves between the fear and the greed which are two extreme ends of the lost prevention and pursuit of reward.
Money, Brain and Profit:
In order to make best decisions that is free from any type of emotions for the financial investment one need to stay rational. There is an economist deep inside each and every individual. The economist in you is the makes you earn your bread and butter by working. However, no one is born with super power of remembering all type of information and making decision free of emotions.
The main problem with individuals and their decision making skills is that they have the urge to carry their entire history of the development with them. This information about development was helpful long ago but today in this modern world, this information is of no good. Today it is important to combine the behavioral patterns of the old times with the logical thinking.
Behavioral Finance has been able to derive the behavioral patterns that can be combined with the logical thinking. Today, an individual who knows and understands these behavioral patterns is capable of knowing his abilities and improving them.
Observations on behavioral economics:
Behavioral Finance has been part of some major research labs and since then there has been a lot of observations made.