Introduction to Behavioral Finance
Behavioral finance aims to focus on articles with direct relevance to practitioners of investment management, corporate finance, or personal financial planning. Given the size of the growing field of behavioral finance, the review is necessarily selective. As it points out, practitioners studying behavioral finance should learn to recognize their own mistakes and those of others, understand those mistakes, and take steps to avoid making them. The articles discussed in this review should allow the practitioner to begin this journey.
Traditional finance uses models in which the economic agents are assumed to be rational, which means they are efficient and unbiased processors of relevant information and that their decisions are consistent with utility maximization. Note that the benefit of this framework is that it is “appealingly simple.” They also note that “unfortunately, after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns, and individual trading behavior are not easily understood in this framework.”
Behavioral finance is based on the alternative notion that investors, or at least a significant minority of them, are subject to behavioral biases that mean their financial decisions can be less than fully rational. Evidence of these biases has typically come from cognitive psychology literature and has then been applied in a financial context.