What is traditional Finance?
Traditional finance assumes people are rational. They have all the information required to make a decision. People are also utility maximizers who act in their self-interest without caring for social issues. The concept relies on mathematical calculations, economic models and regressions. The investors do not have any emotional angle to the investment. Such markets will be very efficient where prices will reflect all the relevant information. An easy way to think about it how financial markets will work in an ideal world.
What is Behavioral Finance?
Behavioral Finance combines the effect of finance and psychology. It observes how humans actually behaves. It argues that human being are irrational. Their decisions are influenced by emotions and biases. It takes inputs from traditional finance and accommodate human emotions .In spite of all the theories available at our disposal, people and markets tend to be irrational most of the times. Many other factors influence the price of investments, ranging from emotional attachment, rumors and the price of the security to good old supply and demand. Clearly, not all market participants are sophisticated, informed and act only on available information.
Eg: Buying a stock because everyone else is buying and it’s a hot stock is an example of behavior finance
Outcome of BF - Cognitive and emotional biases
Cognitive biases are the ones that occur due to lack of information or inability to process information. They are relatively easy to correct.
Not investing in alternate investment due to lack of knowledge in the field is an example of cognitive bias
Emotional Bias happens when decisions are made due to human feeling of joy, hate, revenge, sorrow etc.
Not selling a stock even if the value is high (as per traditional finance perspective) bought by ancestral family member is an example of emotional bias .
Behavioral Finance impact on decision making
An investment decision is a combination of traditional finance and behavioral finance. The goal of studying BF is to increase investor awareness so they make rational decisions and make overall markets more efficient. Working with an advisor will help you overcome some of your biases. However, it is to be noted that the advisor will have his own biases. Advisor can you help you understand your biases and overcome the cognitive ones and adapt the emotional ones if not completely mitigate them. One of the way advisor can help you is by taking contra view of yours.
An rational investor should ask himself and probably document - why am I buying or selling the stock. The answer to the question will help you understand your biases. Having some idea of the behavior pattern of the investors and the market, one can make better decisions to create long term wealth.
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