Question

Traditional financial theory has tended to be based on fundamentals analysis and assumes that financial actors all act rationally to achieve their financial and investment goals. Recently, some scholars have begun to question the rationality assumption and have asserted that many financial decisions have a behavioral aspect that cannot be ignored. Please provide a discussion of what is meant by Behavioral Finance, how it differs from traditional finance, and give some examples of biases or other psychological frames that may be seen as having an impact on investment decision making.

Answer 1

BEHAVIORAL FINANCE

- Behavioral finance is the study of the influence of psychology on the behavior of investors or financial analysts. It also consist the subsequent effects on the markets.

- It majorly emphasis on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.Behavioral finance differs from traditional finance in that it focuses on how investors and markets behave in practice rather than in theory.

- By focusing on actual behavior, behavioral researchers have observed that individuals make investment decisions in ways and with outcomes that differ from the approaches and outcomes of traditional finance.

"Behavioral Finance" is different from "Traditional Finance"

Lets Understand One by One .

Traditional Finance

• Traditional finance assumes that investors are rational: Investors are risk-averse, who process available information in an unbiased way.

• Traditional finance assumes that investors construct and hold optimal portfolios; optimal portfolios are mean–variance efficient.

• Traditional finance hypothesizes that markets are efficient: Market prices incorporate and reflect all available and relevant information.

Behavioral Finance

• Behavioral finance makes different (non-normative) assumptions about investor and market behaviors.

• Behavioral finance attempts to understand and explain observed investor and market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance.

• Behavioral biases are observed to affect the financial decisions of individuals.

Some Examples of Behavioral Biases or other psychological frames that may be seen as having an impact on investment decision making.

1. Overconfidence and illusion of control
2. Self Attribution Bias
3. Hindsight Bias
4. Confirmation Bias
5. The Narrative Fallacy
6. Representative Bias
7. Framing Bias
8. Anchoring Bias
9. Loss Aversion
10. Herding Mentality