Behavioral Finance

By Nathan Reiff

One of the primary conventions of financial theory holds that participants in an economy are essentially rational “wealth maximizers,” meaning that they will make decisions based on the information around them and in a way that is as reasonable as possible. However, in actuality there are countless instances in which emotion and psychology have undue influence upon our decisions, and the result is that “rational” actors can display unpredictable or irrational behaviors.

The branch of economics which is concerned with this paradox is called behavioral finance. This relatively new field seeks to combine behavioral and cognitive psychological theory with conventional economic theory in order to propose explanations as to why people might make irrational financial decisions.

Over the course of this tutorial, we will explain some of the anomalies (i.e., irregularities) which exist in the real world but for which conventional financial theories have not accounted. Additionally, we will aim to provide some insight into a few of the underlying biases and motivators which may cause certain individuals to exhibit irrational behaviors. We’ll also explore how some actors in a financial ecosystem have been able to capitalize on these irrational behaviors. Hopefully, in reading this tutorial, you will be able to better protect yourself against acting against your best interests when it comes to financial matters.

(For related reading, see Taking A Chance Of Behavioral Finance and Leading Indicators Of Behavioral Finance.)