Behavioural Finance

Behavioural Finance

Finance is a field of economics. In turn, economics is a social science studying production, distribution and consumption of resources, goods and services. Alternatively, psychology is also a social science focusing on the mind and behaviour. A seemingly unlikely blend of these two disciplines creates the discipline of behavioural finance. Thus, behavioural finance combines financial theory and cognitive psychology to explain how people make decisions in the financial world, and how often these decisions end up being irrational.

Along these lines, behavioural finance shows that the human factor, particularly human psychology, influence investment decisions and even market outcomes. Behavioural finance emerged as an explanation as to why the efficient financial market theory fails to show the whole picture when it comes to investors' decisions and financial markets' fluctuations. The main argument in behavioural finance is that human beings are rational agents seeking to maximize wealth. However, in practice this is not always the case. Thus, human emotion and other psychological aspects explain why sometimes investment decisions appear rather irrational.

Moreover, conventional financial theories cannot explain all the decisions made, and psychology seems to play a role. Often it has been said that to be a successful investor, one needs to be the perfectly balanced individual between an emotional one and a completely unemotional one. For example, many investments fluctuate according to the market. If an investor is very emotional, he or she may sell their stocks and bonds ahead of time, losing money in the process, while if they just waited a while longer the price of the shares or commodities would go back up. Thus, behavioural finance looks at all these elements and attempts to reconcile and explain the anomalies or irregularities of financial and investing decisions.

Related aspects are sunk costs, cutting one's losses and risk tolerance. For example risk tolerance is a criterion often used by financial consultants and asset managers in choosing portfolios for their clients. However, risk tolerance is likewise a psychological concept and has often much to do with a person's personality and general outlook on life. Indeed, psychologists propose a theory, known as the The Big Five, as determinants of personality. Openness to novel experience is one of the determinants and it may be argued that it has much to do with optimism and pessimism, which in turn may be related to investor risk tolerance and risk aversion.

People often say that financiers marry psychologists, whether that is true or not remains highly debated, and also lays far beyond the scope of the present essay. However, finance, as a subject, can be married to psychology, and hence the emergence of behavioural finance. Nonetheless, behavioural finance incorporates elements from many other social sciences, such as sociology, political science and anthropology, resting on the the premise that financial fundamentals should not be viewed in isolation from the rest of the social world. Economics, from which finance is a derivative discipline, is, after all, likewise a social science.

Where the property is located is very important to determine real estate value. Image: Megan Jorgensen (Elena)

Alternatively, to look at a purely financial topic, let’s take the subprime mortgage crisis. The crisis shook the United States and the world, and many would argue pushed the world into an economic recession. Business cycle theory predicts economic recessions and expansions. Also, a subprime borrower is someone with a dubious credit history, or someone whose creditworthiness is under doubt. The human factor led many banks to lend money through mortgages to these subprime borrowers and the whole card castle collapsed one day, as it could be predicted that it would.