Question

Briefly discuss the application of behavioral finance to market bubbles and other financial decisions.

Answer 1

It is believed that the financial markets are efficient in nature and that the investors are rational in their behavior. In other words, the investors take a decision based on proper information. The efficient market hypothesis states that all the information is openly available in the market. The investor will therefore make an informed decision. But in many cases it has been observed that the investors have not taken the decision rationally. Therefore, there is a need to study the behavior of the investors and gain better knowledge about the way they react and respond. This led to the beginning of the area of study in finance i.e. Behavioral finance. The behavioral finance consists of the study of biases, mental accounting, herd behavior, high self rating. The term bias refers to the partial behavior of a person towards another. In terms of behavioral finance, it refers to the partial behavior of an investor towards a given stock. The term mental accounting means the allocation of money that the investor has to the various investment opportunities in the market. Herd behavior refers to the mentality of the investor to follow the other investors. The lack of own decision making power and the tendency to follow the others blindly is known as herd mentality. The term high self rating refers to the belief that one's decision is the best. The market bubbles and financial decisions of the investors in the market will be understood better through the knowledge of behavioral finance. This will help in predicting the behavior of the investors and the market movement.