What is the most common assumption economists make while formulating theories? That man is rational. Yet sometimes we see weird things happening in the stock market, economic bubbles being the biggest example. If man was so rational, then why did the dot com bubble happen or for that matter any bubble?
After a lot of study the only answer that became clear was, apart from economic and company related factors, there were other factors which had an impact on the stock market. Psychological, social, cognitive, and emotional factors affected the economic decisions of individuals and institutions and had consequences on market prices, returns, and the resource allocation. The study of psychological factors on economic decisions is termed as behavioral finance. In other words, they developed a fancy new field to explain mans irrationality!
To understand this better let us take an example, X buys a car with the aim of selling it after 5 years to get a good return, after 5 years X has now reached the point of selling the car, but he gets attached to the it, after all there are so many great memories attached to it. No, he can’t sell it, not this year at least. If here we assume the economic theories then X should sell the car, as with each passing year the value of the car is falling. Taking such events into account and to understand them better behavioral finance came into existence. Here are a few exciting concepts which explain investor behavior beyond his rationality:
There are situations were certain investors have 2 portfolios, one is a safe portfolio which offers an assured return and another is a speculative portfolio which is for capital gain. The assumption with this approach is that the losses of the speculative portfolio will be set off by the safe one, however what the investor does not understand is that his income will not be any different than if he held one large portfolio. This is called mental accounting.
Another interesting theory of behavioral finance is anchoring, which states that people attach their thoughts to a reference point even though it may have no logic. In an additional concept called the confirmation bias, behavioral finance states the investor is likely to seek out information which supports his original idea. This stems from the psychological concept of selective thinking which enunciates that first impressions are hard to shake because people tend to think selectively.
There are many more theories which explain why stock market reactions take place the way they do. However, behavioral finance is still a very young field and it will take a lot more research to formulate hard bound theories and strategies. Researchers believe that behavioral finance is best used to aid investors’ decision making and it is unclear whether or not funds using behavioral finance strategies are effective.