Question

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 is a sub-field of behavioral economics. It suggests that mental psychological biases and influences influence the the financial behaviors of investors & financial practitioners. Also, biases and influences can explain a wide range of market abnormalities-specifically anomalies in the stock market, for example, extreme ascents or falls in stock price. Behavioral finance attempts to understand & explain observed investor & market behaviors. This is different from traditional (standard) finance, which is based on hypotheses about how investors & markets should behave. That is, behavioral finance differs from traditional finance in that it focuses on how investors & markets behave in practice rather than in theory.

Disposition bias refers to when investors sell their winners and hang onto their losers. Confirmation bias is when investors have a bias toward accepting information that confirms their already-held belief in an investment. An experiential bias occurs when investors' memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. The familiarity bias is when investors tend to invest in what they know, such as domestic companies or locally owned investments.