What is Behavioral Finance?
Behavioral finance is a part of finance. It looks at how people think and feel when they make choices about money and risk. This is different from traditional finance ideas. Those ideas say people should make smart choices to get the best results. But behavioral finance shows real people do not always work that way.
Emotions and Money Choices
Behavioral finance says emotions change how we think about money. When people feel good, they might take bigger risks. They believe good things will happen. But when they feel bad, they are more careful. They want to avoid losing money.
Falling in Love With Investments
People get attached to things they own. This includes stocks they buy. They don’t want to sell a stock, even if it is losing money. They wait too long to sell. They hope the stock will go back up.
Chasing Trends
When a stock is going up, more people buy it. They see others making money and want to join in. They think the stock will keep going up. This can make the stock price go up more. But the stock may crash later when the trend stops.
Blind to Flaws
People don’t like hearing bad news about things they own. If you own a stock, you might ignore signs of trouble. You focus on good news and think the stock is better than it is. This is called confirmation bias.
Moving With the Crowd
People often follow the crowd in money matters. When they see everyone else buying or selling, they do the same. They assume the crowd must know something they don’t. This can lead to stock prices rising or falling fast.
Loss Hurts More Than Gain Feels Good
Research shows people hate losing $100 more than they like winning $100. Losing money feels extra painful. This can make investors too scared of risk. They might avoid good opportunities because they fear any chance of loss.
Holding Losers Too Long
Because losses feel so bad, people avoid admitting they picked a loser. They keep a losing stock instead of selling it. They don’t want to lock in a loss. They hope the stock will come back. This is the sunk cost fallacy.
Following Experts Blindly
Many people want experts to tell them what to do with their money. They think experts can predict what markets will do. But research shows even experts are often wrong. Blindly trusting experts can lead you astray.
The Simple Road to Riches
People want easy answers for making money. They believe simple rules can make them rich. They fall for strategies like “buy what you know” or “invest in the next big thing.” But investing is rarely that simple.
Reusing Recent Information
When making money choices, we rely too much on the latest news. If a company just announced good earnings, we think that means it will do well in the future. We forget to look at the long-term picture. We overweight new data.
Ignoring Luck
It’s hard to tell luck apart from skill. If an investor beats the market a few times, people say she’s a genius. But it could just be luck. Most managers who outperform one year don’t continue winning. Luck plays a big role in investing.
The Truth About Patterns
Humans love finding patterns. When we look at stock charts, we see trends and shapes everywhere. We think lines and patterns predict the future. But evidence shows most stock charts are random noise. Patterns in them do not forecast future moves.
Forecasting Follies
We tend to think the future will look like the recent past. During a bull market, people forecast high stock returns to continue. During a bear market, they expect more losses ahead. But markets move in cycles. The next phase is usually unlike the last one.
Framing and Biases
How you ask a question affects how people answer. This is framing. With investing, it matters how you frame risk and reward. People avoid gambles that emphasize loss. But they prefer gambles that emphasize gain. They focus on the frame you use.
Swayed By What’s Available
When judging, we rely heavily on information that’s easily available. This is the availability bias. Investors give too much weight to vivid, recent events. They overreact to big news stories. They neglect deep, long-term research.
The Madness of Crowds
Group psychology can overpower individual smarts. In a bubble, people egg each other on. They throw out their normal decision rules. They believe “this time is different.” The crowd madness blocks out doubters. It lasts until the bubble pops.
Planning vs. Doing
We plan to make smart, disciplined choices. But in the moment, we often don’t follow our own plans. Emotion takes over. We buy high and sell low, the opposite of good investing. Our feelings in the moment overrule our long-term strategy.
Knowing Ourselves
Behavioral finance teaches us our own minds work against us. We make mistakes with money because of strong forces we often don’t notice. To invest better, we must first know ourselves. We need to see how biases sneak into our thoughts.
Outside Help
One solution is using rules and algorithms to make decisions. Taking human choice out of the process can avoid mistakes. Setting a plan and sticking to it helps.
Education and Insights
Studying behavioral finance helps us spot errors in our thinking. We can’t avoid all mistakes. But we can know our weak spots. We can pause before trading. We can ask if a bias is fooling us.
