Behavioral finance

From ArticleWorld

Behavioural finance refers to the study of cognition thought processes such as emotion, memory and perception and how they influence the making of economic decisions. The interest lies in the market place and public choice.

The emergence of cognitive psychology in the 1960’s and its view of the brain as a device which processes information led to a resurgence of the use of psychology to explain the rationale behind market prices, returns and allocation of resources.

Issues in behavioural finance literature include the lack of correlation between buying and selling or acquiring and keeping resources as well as the impact on the market place of resources which are of emotional value, such as a house.

Three main themes

Behavioural finance is concerned with three main areas:

  1. Heuristic, or trial and error. It is seen that people often make decisions not on rational analyses but on approximations.
  2. Framing. Presentation of a problem makes a difference to what choice will be made.
  3. Market inefficiencies such as irrational decision making and return anomalies. These occur not because of individual biases but because of collective group behaviour.


Critics of the behaviour finance approach are supportive of the theory which espouses an efficient market. They maintain that behaviour finance is concerned with a collection of phenomenon which would eventually be averaged out by the market. Supporters of behaviour finance reply that while they may be correct as regards individual biases, collective or social biases do have an influence on price and market behaviour that cannot be dealt with by the market as a force.