For decades, psychologists and sociologists have pushed back against the theories of mainstream finance and economics, arguing that human beings are not rational utility-maximizing actors and that markets are not efficient in the real world. The field of behavioral economics gained momentum in the late 1970s to address these issues, accumulating a wide swath of cases when people systematically behave "irrationally." The application of behavioral economics to the world of finance is known, unsurprisingly, as behavioral finance.

From this perspective, it's not difficult to imagine the 澳洲幸运5官方开奖结果体彩网:stock market as a person: It has mood swings (and price swings) that can turn on a dime from irritable to euphoric; it can overreact hastily one day and make amends the next. But can 澳洲幸运5官方开奖结果体彩网:human behavior really help us understand financial matters? Does analyzing the mood of the market provide us with 🥂any hands-on strategies? Behavioral finance theorists s🐎uggest that it can.

Some Findings from Behavioral Finance

Behavioral finance is a subfield of 澳洲幸运5官方开奖结果体彩网:behavioral economics, which argues that when making financial decisions like investing people are not nearly as rational as 澳洲幸运5官方开奖结果体彩网:traditional finance theory predic꧒ts. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some☂ interesting descriptions and explanations.

The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that financial markets are efficient. Proponents of the 澳洲幸运5官方开奖结果体彩网:efficient market hypothesis (EMH), for instance, claim that any new information relevant to a company's value is quickly priced by the market. As a result, future price moves are random because all available (public and some 澳洲幸运5官方开奖结果体彩网:non-public) inform🌳ation is already discounted in current values.

However, for anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. 澳洲幸运5官方开奖结果体彩网:Behaviorists explain that, rather than being 澳洲幸运5官方开奖结果体彩网:anomalies, irrational behavior is commonplace. In fact, researchers have regularly reproduced examples of irrational bꦺehavior outside of finance using very simple experimentsඣ.

"It's understated to say that financial health affects mental and physical health and vice versa. It's just a circular thing that happens," said Dr. 澳洲幸运5官方开奖结果体彩网:Carolyn McClanahan, founder & director of Financial Planning at Life Planning Partners Inc. "When people are under stress because of finances, they release chemicals called catecholamines. I think people have heard of things like epinephrine and stuff like that, that kind of put your whole body on fire. So that affects your mental health, affects youౠr abilitꦐy to think. It affects your physical health, wears you out, makes you tired, you can't sleep. And then once you can't sleep, you start to have bad behaviors to deal with that."

Thꦉe Importa😼nce of Losses Versus Significance of Gains

Here is one experiment: Offer someone a choice of a sure $50 or, on the flip of a coin, the possibility of winning $100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of 1) a sure loss of $50 or 2) on a flip of a coin, either a loss of $100 or nothing. The person, rather than accept a $50 loss, will probably pick the second option and flip the coin. This is known as 澳洲幸运5官方开奖结果体彩网:loss aversion.

The chance of the coin landing on one side or the other is equivalent in any scenario, yet people will go for the coin toss to save themselves from a $50 loss even though the coin flip could mean an even greater loss of $100. That's because people tend to view the possibility of recouping a loss as more important than the possibility of greater gain.

The priority of avoiding losses also holds true for investors. Just think of Nortel Networks 澳洲幸运5官方开奖结果体彩网:shareholders who watched their stock's value plummet from over $100 a share in early 2000 to less than $2 a few years later. No matter how low the price drops, investors—believing that the price will eventually come back—often hold stocks rather than suffer the pain of 澳洲幸运5官方开奖结果体彩网:taking a loss.

The Herd vs. Self

The 澳洲幸运5官方开奖结果体彩网:herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a ♔consequence, investors feel a strong impulse to ♔do what others are doing.

Behavior finance has also found that investors tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock.

On the other hand, beliefs are not easily shaken. One notion that gripped investors through the late 1990s, for example, was that any sudden drop in the market is a buying opportunity. Indeed, this 澳洲幸运5官方开奖结果体彩网:buy-the-dip view still pervades. ♛Investors are often overconfident in their judgments and tenꦫd to pounce on a single "telling" detail rather than the more obvious average. In doing so, they fail to see the larger picture by focusing too much on smaller details.

How Practical Is Behavioral Finance?

We can ask ourselves if these studies will help investors beat the market. After all, rational shortcomings should provide plenty of profitable opportunities for wise investors. In practice, however, few if any 澳洲幸运5官方开奖结果体彩网:value investors are deploying behavioral principles to sort out which 澳洲幸运5官方开奖结果体彩网:cheap stocks actually♔ offer returns that are consisten😼tly above the norm.

The impact of behavioral finance research still remains greater in academia than in practical 澳洲幸运5官方开奖结果体彩网:money management♔. While theories point to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias.

Robert Shiller, the author of "Irrational Exuberance" (2000), showed that in the late 1990s, the market was in the thick of a bubble. But he couldn't say when the bubble would pop. Similarly, today's behaviorists can't tell us when the market has hit a top, just as they could not tell when it would bottom after the 2007-2008 financial crisis. They can, however, describe what an important turning point might look like.

Frequently Asked Questions

What does behavioral finance tell us?

Behavioral finance helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitat💃ions of the mind in proces♔sing and responding to information.

How does behavioral finance dif💟fer from mainstream financial theory?

Mainstream theory, on the other hand, makes the assumptions in its models that people are rational actors, that they are free from emotion or the effects of culture and social relations, and that people are self-interested utility maximizers. It also assume🍷s, by extension, that markets are efficient and firms are rational profit-maximizing organizations. Behavioral finance counters each of these assumptions.

How does knowing about behavioral finance help?

By understanding 💛how and when people deviate from rational expectations, behavioral finance provides a blueprint to help us make better, mor🐼e rational decisions when it comes to financial matters.

The Bottom Line

The behavioralists have yet to come up with a coherent model that actually predicts the future rather than merely explain, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes 澳洲幸运5官方开奖结果体彩网:market prices and fundamental va🌠lues to diverge for a long time.

Behavioral finance offers no investment miracles to capitalize on this💙 divergence, but perhaps it can help investors train themselves on how to be watchful of their behavior and, in turn, avoi♉d mistakes that will decrease their personal wealth.