Question

What is behavioral finance? What are the implications of behavioral finance for market efficiency?

Answer 1

Behavioral finance:

Behavioral finance is less about numbers and more about psychology and the influence of human behavior on financial decisions.

Behavioral finance revolves around biases that humans have and how it can affect the decision-making power of an investor.

Behavioral finance clearly disregards the theory of market efficiency and it suggests that till the time humans have emotions which eventually leads to the biases to creep in and therefore sooner or later both the market and humans will fail to show the correct picture about anything.

Talking about biases, there are a lot of them, let's discuss a few of them:

a. Confirmation bias: This is where investors first pick the company they want to invest in and then any information which they gather or anyone who they talk to will only lead the investor to be more inclined towards the idea of investing in that particular company

b. Cognitive bias: “I don’t know that I don’t know” – Dunning Kruger effect, where the investor inflates the self-assessment of his or her abilities.

Behavioral finance is not a new thing as people like “John Maynard Keynes”, “Ben Graham”, “Charles Munger” etc. have been talking about for decades and clearly the market efficiency theory stands no ground in their life as an investor.