Financial decision-making can be beset by various cognitive biases, including heuristics and framing, anchoring and self-attribution biases.
Behavioral finance investigates the psychological influence on financial decisions and market efficiency, which poses an existential challenge to the efficient markets hypothesis, which holds that stock prices reflect all relevant information.
How your emotions affect your financial decisions
Behavioral finance utilizes modern economic psychology to understand why investors often make emotional financial decisions that go against their best interests. Behavioral finance differs from traditional economic theory such as Efficient Market Hypothesis (EMH) by acknowledging how psychological influences such as emotions and biases may impact decisions that go against one’s best self-interests.
Economics of arbitrage is an interdisciplinary field of study which upends some Nobel Prize-winning theories of how economies and financial markets work. Cognitive psychology addresses how people’s subjective thinking distorts rational judgment; limits to arbitrage indicate when arbitrage forces will become effective or ineffective.
Kleinwort Hambros recently conducted a survey that revealed more than half of those under 35 admit they are emotionally driven when it comes to making financial decisions, compared with only 31% among people aged 35-54 and just 6% among those over 65.
Why you’re afraid of losing money
Behavioral finance seeks to understand why investors appear impulsive and make decisions against their own best financial interests. Furthermore, this discipline challenges some established Nobel prize-winning theories on how economies and markets operate.
Understanding how emotions influence decisions is vital to making smarter money moves. Recognizing irrational fears that can set back financial plans can also be helpful in making better financial decisions.
Many people fear spending the savings they’ve been saving because they fear they will lose it, which could cost them opportunities like taking a trip or buying a house. Another cause for fearing losing money may be their desire for security which leads them to oversave and hoard. Behavioral science can assist individuals overcome such hurdles while building healthy relationships with money.
Why you’re tempted to over-leverage yourself
At times of global volatility and uncertain economies, investors can feel pressure to sell or buy. Yet behavioral studies demonstrate the importance of using available data instead of making emotional decisions when investing.
Behavioral finance is an area of economics that studies how psychological influences and biases impact financial decisions. This theory offers explanations for market anomalies such as herding, loss aversion, confirmation bias and familiarity bias that exist today.
Though popular, behavioral finance remains controversial. Eugene Fama of the University of Chicago remains one of its fiercest critics; he maintains that behavioral finance is just a passing fad; human tendencies do not cause anomalies in market prices as suggested by behavioral finance theory; instead it simply provides explanations for trends and patterns discovered through data mining techniques rather than superseding efficient-market theory altogether. Yet this field has come far since its initial days.
Why you’re tempted to spend on material possessions
At times it can be tempting to indulge in material possessions for their aesthetic value and the short-term pleasure they can provide. Unfortunately, spending your hard-earned cash on material possessions won’t do much good financially speaking as these purchases depreciate over time and won’t generate interest, necessitating replacement later.
Behavioral finance is an area of research which investigates the influence of psychology and human behavior on financial decision-making. Behavioral finance seeks to explain why markets often deviate from mainstream finance theory such as Efficient Market Hypothesis (EMH), which assumes investors and firms to be rational profit-maximizing entities.
Understanding how emotions influence financial decisions is a key step toward avoiding costly errors in the future. If status seeking or envy are driving your decisions, acknowledging and managing these emotions are vital steps toward creating better outcomes for both yourself and your family. Otherwise, unwise financial choices could have detrimental financial ramifications.