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Importance of behavioral finance

by Thomas
behavioral finance

Reading some of their books opened my mind about the importance of behavioral finance, it’s not something trivial because you’ll have another perspective.

Thanks on the studies done goes two psychologists Daniel Khaneman and Amos Tvesrky, Daniel in 2002 won the Nobel Prize in Economics this to show you how much mind influences our decisions.

Behavioral finance compares it to a kind of science that analyzes the financial choices of investors, it is true that today algorithms are taking the place of humans but it is correct to say that they are programmed by humans. I do not want to enter algorithms chapter, I will have time in the future, I want to talk about behavioral finance to show you the different perspectives that affect the functioning of the markets:

  • Emotions
  • Prejudices
  • Self-control
  • Instinct
  • Irrationality

These ingredients put together constitute behavioral finance, human mind is very complex in fact it continuously affects the choices of traders that will reproduce with markets’s trend.

Not only traders but also savers themselves are included in the set of behaviors, for example when they allocate money for specific purposes (savings, pension, heritage), mentally it creates an emotional process based on emotions such as euphoria in case of profits while anger, fear, anxiety in case of losses.

You see that emotions play a key role in choices, very often they are irrational decisions that risk overwhelming us as if it were a herd of crazy bulls. Psychologists and sociologists through behavioral finance try to understand how people react to the problems of evaluation and processing of data to which they are subjected every day, analyzing a series of rational and irrational mental processes that influence their choices.

Several studies have shown that investors are averse to loss over a gain because they are more emotionally involved, in fact in my experience when people ask me: Thomas, but is there a risk-free investment?  I always perceive an individual’s desire to leave capital intact rather than take a risk in the face of a potential gain.

You have to understand that there is no efficient and optimized market, you have to analyze the way psychological factors affect a purchase or sales order, the skill of a trader or fund reside in understanding of behavioral financial trends (price analysis, volatility…).

3 topics on which behavioral finance is based:

  • Market inefficiencies: moments when the market reacts in an incomprehensible way outside of any rational logic
  • Heuristics: people make a decision about a situation based on their experience, not on probabilities such as statistics/mathematics
  • Frame: Your decision will be influenced by how you will be presented with a situation

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