Behavioral finance is a famous field of finance that suggests theories based on human psychology (financial psychology or behavioural economics) in order to explain the concept of stock market anomalies, which includes extreme rise and fall in the prices of stocks.
Behavioral finance suggests that the structure of the information and characteristics of participants of the market plays an important role in 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 active management.
- Individuals, who believe in the fact that markets are rational and the prices are inclusive of all type of information available, are capable of relying on passive management.
Psychology and 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 centers are developed and interacted in a very different way.
- Limbic System deals with the Emotions.
- Cortex deals with Logic
- Recumbent Part deals with body 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, conceptualizing, logical thinking, calculating and making financial planning. Cortex works slowly and takes time to make an investment decision.
These two parts of the brain plays a very important role in decision making. Both of these work in very different way, but these 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 stock market: The entire market moves between the fear and the greed which are two extreme ends of loss prevention and pursuit of reward.
Psychology and Economics
In order to make best financial decisions,which is free from any type of emotions for financial investments, one need to stay rational. There is an economist deep inside each and every individual.
The economist in you,makes you earn your bread and butter by working. However, no one is born with super powers, of remembering all type of information, and making decisions 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 development with them.
This information about development was helpful long ago, but today in this modern world, that type of information is no good. Today, it's important to combine the behavioural dynamics of the old times with the logical thinking.
Behavioral Finance has been able to derive the behavioral dynamics that can be combined with the logical thinking. Today, an individual who knows and understands these behavioral science is capable of knowing his abilities and improving them.
What is 'Behavioral Economics'?
Behavioral Economics is the study of psychology and finance, as it relates to the decision-making process behind an economic outcome of individuals and institutions.
Nobel Prize in economics has already been awarded to a number of behavioral finance theorists that includes Daniel Kahneman, Richard Thaler and few more.
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.