Behavioral Finance – Definition, founding fathers, theory and criticisms

Behavioral finance attempts to fill the gap created by various studies which try to explain the long-term historical phenomena in efficient market hypothesis (Investopedia, 2013). Conventional financial theory suggests that the market and its economic agents are rational wealth maximisers (Phung, 2009). However, emotions and psychology may affect our decisions in various ways. Since such decisions are related to our psychological and emotional aspects, they may result in various social effects such as loss aversions and depression. Anything related to psychological and emotional factors have social effects on individuals. The most important contribution of behavioral finance is that it has established various anomalies that most financial theories have failed to explain. Such anomalies are also referred to as irregularities or errors. Behavioral economics asks why some economic agents behave irrationally. Biases in decision making may cause irrational behaviors in market participants and such irrational behaviours are often against their interests (Phung, 2009).

Conventional economics and finance assume that economic agents make rational decisions in order to improve their wellbeing. In reality, people often behave irrationally (Frankfurter, 2009). Such irrationality is explained by psychological theories as the foundation of behavioral finance. Behavioral finance explains the anomalies and behaviours that rational financial theories could not explain. Phung (2009) suggests that the rational financial theories could explain certain idealized events, but the market place has proved to be a messy place where participants behave in an unpredictable manner. Conventional economics also suggests that emotions and other extraneous factors do not influence people’s economic decision making. Behavioral finance has attempted to include the fact that people frequently behave irrationally in economic decision making. A good example of irrational behaviors is gambling. It is quite irrational when someone buys an expensive lottery ticket where only one person among 1 million people can win the lottery. Behavioral finance takes into consideration cognitive psychology in order to explain the irrational and illogical behaviors made by economic agents and market participants in economic decision making.

Like any other economic field, behavioral finance has its own founding fathers. The fathers of behavioral finance are: Daniel Kahneman and Amos Tversky. The two have collaborated to produce over 200 works, most of which apply psychological concepts that have implications in behavioral finance. Kahneman received the Nobel Memorial Prize in Economics Sciences in 2002 for being a great contributor to the study of economic rationality. The duo has carried out good research in heuristics and cognitive biases that result in unanticipated irrational behavior among individuals. They published writings about prospect theory and loss aversion. Richard Thaler helped in the evolution of behavioral economics. He blended economics and finance with psychology to come up with such concepts as: the endowment effect, mental accounting and other biases.

Behavioral finance has also been criticized over time. Supporters of efficient market hypothesis are the most vocal critics of the behavioral finance theories. Efficient market hypothesis is a foundation of modern finance theories. The theory assumes that the market price of a security shows the impact of all the relevant information. Eugene Fama, the founder of market efficiency theory, suggests that market efficiency should not be totally abandoned despite the anomalies that are not explained by modern financial theory. He argues that most of the anomalies in economic decision making are short-term chance events which can be corrected after some time. He also claims that findings of behavioral finance seemingly contradict each other, and appears to be made up of several anomalies that market efficiency theories can explain.

Leave a Reply

Your email address will not be published. Required fields are marked *