Behavioral finance is a sub-field of behavioral economics. This theory proposes that there are effects from psychological influences and biases toward the investors’ and financial practitioners’ behavior.
Thus, knowing these influences and biases are essentials to predict all types of market anomalies. That is true, especially on the market anomalies in the stock market, like extreme rises and falls in stock price.
The Detail Definition
There are various perspectives available if you want to analyze behavioral finance. Commonly, people analyze the effect of psychological behaviors on the stock market return. But, the truth is, there are many different angles available for observation.
The classification of that angles for observation aims to help us understand why people make specific financial choices, as well as, the ways that decisions affect the market.
Besides, this theory also assumes that the participants of the financial market are not perfectly self-controlled and rational. But, they are rather psychologically influential with self-controlling.
The main aspect of this theory is in the influence of biases. That biases may be essential to narrow the study or analysis of the certain industry or sector outcomes and results.
The concepts of Behavioral Finance
There are basically five main concepts in this theory.
Mental Accounting
It is the propensity for investors to allocate money for their own goals.
Herd Behavior
This behavior makes people have the tendency to mimic the majority of the herd’s financial behavior. Therefore, this behavior is popular for the cause behind the extreme sell-offs and rallies in the stock market.
Emotional Gap
This is a decision-making process based on extreme emotion strains, like anger, fear, excitement, or anxiety. Like we all know, emotions, most of the time, become the main reason people making irrational choices.
Anchoring
It refers to attaching a spending level to the specific reference. For example, an investor can be spending budget levels based on the satisfaction utilities.
Self-Attribution
This behavior refers to the tendency of people making choices based on confidence in one’s self-based knowledge. It, naturally, stems from intrinsic confidence in a specific area.
