Behavioral Finance

Behavioral finance is a field of study that combines psychology and Economics to understand how emotional and cognitive biases influence the financial decisions of individuals and markets. It challenges the traditional assumption that investors are rational actors who make decisions purely based on available information.

Key concepts include:

• Overconfidence: Investors may overestimate their knowledge and predictive abilities, leading to excessive trading and risk-taking. For instance, a trader might believe they can predict Stock price movements based on their recent success.
• Loss Aversion: Investors often prefer to avoid losses rather than acquiring equivalent gains, which can lead to holding losing investments for too long. An example is an investor who holds onto a declining Stock hoping it will rebound instead of cutting their losses.
• Herd Behavior: Individuals may follow the actions of a larger group rather than their own analysis, resulting in market bubbles or crashes. For instance, during the Dot-com bubble, many investors poured Money into tech Stocks due to widespread excitement, ignoring fundamental valuations.

Cases illustrating behavioral finance include:

• The 2008 financial crisis, where many investors ignored risks due to overconfidence in the housing market.
• The GameStop trading frenzy in early 2021, which showcased herd behavior among Retail Investors rallying around a single Stock despite its underlying fundamentals.