Finance which examines the actual decision-making processes of investors is known as Behavioral Finance. Many observers think that investors are not the rational utility-maximizing decision makers with complete information that Traditional Finance assumes they are. Behavioral Finance is the study of the psychology influence on the behavior of Investors or Financial Analysts. Behavioral Finance focuses on the fact that Investors are normal and not always Rational, have limits to their self-control, and are influenced by their own biases.
Beliefs of Traditional Finance
- Market and Investors both are rational.
- Investors have full control
- Investors care about utility Maximizing decisions
Behavioral Finance Traits
- Investors are assumed as “normal” not “rational”
- They actually have limits to their self-control.
- Investors are generally influenced by their own bias
Behavioral Finance examines whether investors behave rationally, how Investor Behavior affects Financial Markets and how Cognitive Biases may result in anomalies. Behavioral Finance describes Investor Irrationality but does not necessarily refute Market Efficiency as long as Investors cannot Consistently earn abnormal risk-adjusted returns..
In 1990, Behavioral Finance emerged as a field of Financial Economics which explores how psychological behaviors, Traits, and Reactions of Investors impact the Investment Decisions making Process.
Consider Investor behavior that creates some degree of systematic mispricing of securities and may explain some anomalies that tend to refute the efficient market hypothesis.
1.Overconfidence Bias: Analysts are overconfident in their earnings forecasts and their (high) estimated growth rates of earnings lead them to overemphasize the impact of good news and tend to underestimate the negative value implications of bad news . This generally results in excess trading, higher expenses and taxes, more risk-taking and lower net returns.
2.Confirmation Bias: People seek out supporting information after making a decision and avoid or ignore new information that would call the decision into question. A belief that Reliance is a good company with high growth may be extended by investors to include a belief that Reliance stocks are ‘good’ stock.