What is Behavioral Finance?

The concept of behavioral finance has to do with taking into consideration a range of psychological variables and how the resulting emotional reactions of these variables can impact both personal and general economic conditions. Closely associated with behavioral economics, the concept seeks to explain what occurs when emotional responses are involved in decisions that impact the stock market and the prices of individual stocks, market prices in selected markets, and the allocation of financial resources in both savings and spending habits. Here are some examples of the types of factors that are normally taken into account by behavioral finance theorists.

There are three generally accepted factors that come into the research and identification of behavioral variables as they are related to the study of behavioral finance. One factor is referred to as heuristics. The idea here is that investors may choose to make economic decisions based on some type of personal set of ideas or values that may or may not be related to basic economic principles. Heuristics do not have to follow a logical pattern to anyone but the investor, nor do they have to necessarily be based on such factors as performance history. Often, these factors may seem completed irrelevant to the outsider, even as they make perfect sense to the investor.

Framing is a second factor that is taken into consideration when studying behavioral finance. This refers to the way that a financial problem or opportunity is presented to the investor. According to the various behavioral finance theories, the verbiage and presentation of the situation to the investor will greatly influence the decision that is made. The idea is that if the same facts were presented with a different approach, the decision reached by the investor would likely be different.

The third basic factor of behavioral finance is referred to as market inefficiencies. Perhaps the most logical of the three basic factors, market inefficiencies still tend to be outside the scope of universally accepted explanations for market performance. Essentially, this factor of behavioral finance looks at the outcome of an event in the marketplace and identifies contributing elements that experts may or may not have acknowledge as playing a role in the outcome. Examples of market inefficiencies include such events as taking market anomalies and making them into market indicators, and isolated events where goods or services are priced incorrectly.

Behavioral finance is an ongoing process, with the effectiveness of the process being hotly debated in some quarters. Still, the discipline does attract a great deal of attention, and there is no doubt that research using behavioral finance as the basis will continue.