Behavioral finance is the study of investor behavior, individually and collectively, as it is observed in the market. Traditional finance assumes that markets are rational. It is because if individual investors are irrational, others observe the deviation and respond accordingly, but behavioral finance argues that such reinforcement of rationality does not occur in reality in financial markets and that individual and collective biases can potentially explain why pricing anomalies exist.

Risk aversion vs loss aversion

Traditional finance argues that rational investors are risk-averse, i.e. they want to avoid risk if it is not properly compensated in the expected return. Behavioral finance, on the other hand, contends that investors loss averse. Loss aversion is the observation that people dislike losses more than they like gains of the same magnitude. They can potentially explains the overreaction anomaly.

Herding

Herding occurs when people trade in accordance with the overall market system while ignoring their own private analysis. Herding results in momentum and overreaction anomalies.

Overconfidence

Overconfidence is a behavior bias in which investors overestimate their ability to process and analyze new information which leads to mispricing in financial markets. Even though such mispricing tends to correct itself over time, it may persist in some markets, particularly in the case of growth stocks.

Information cascade

Information cascade is the transmission of information from market influencers. Information cascade is most important with reference to accounting information because accounting information is difficult to interpret and noisy. In such a situation, uninformed investors follow the actions of informed traders and this can potentially lead to overreaction anomalies. Some researchers argue that information cascades that cause the market to move to an incorrect value are fragile and ought to be corrected automatically. Information cascades are greatest in case of companies with poor quality disclosures, but they can nonetheless help in dissemination of information in the market.

Other behavioral biases

Other common behavioral biases include:

  • Representativeness: when investors see new information from the current frame of reference;
  • Mental accounting: when investors treat principal and gains differently;
  • Conservatism: when investors stick to their existing opinions
  • Narrow framing: when investors look at things in isolation and not at the bigger picture.

Behavioral finance can help investors understand psychological factors that affect decision making and enables them to make better decisions, individually and collectively. If we define market efficiency as non-existence of any pricing anomaly, markets are not efficient, but if market efficiency is defined as whether someone can earn abnormal returns consistently, markets are efficient.

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