Behavioural Finance in the Field of Finance and Investment

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Introduction

The intention of this essay is to analyse the development of ‘Behavioural Finance’ within the field of finance and investment. It will highlight some of the literature that has come about as a result of research in the field, some of the implications it has had on historical theories and some of the implications it has had within the world of investment.

The Birth of Behavioural Finance

Behavioural Finance is considered by many to be a new field within finance, but it does have its origins in the early 20th century. One of the initial publications to highlight the importance of investor psychology was authored in 1912 by George Selden, the intention of this book was to discuss the “belief that the movements of prices on the exchanges are dependant to a very large degree on the mental attitude of the investing and trading public”(Selden, 1912, pp. Preface), this was a pioneering thought and began the start of linking psychological aspects within the world of finance. Throughout the 20th century, many developments were made in relation to combining psychological aspects to the world of finance. Since George Selden, many have built upon this idea and “in 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance.”(Sewell, 2010, p.1). This was of importance as considering the dynamic nature of finance, a decision one makes can often be offset by the introduction of new and inconsistent information, this may often lead practitioners to make irrational decisions which in turn affects markets, pricings and causes inefficiencies. After this, John Pratt “considers utility functions [and] risk aversion”(Sewell, 2010, p.1), which considers how practitioners evaluate a monetary amount gained or lost and also how they feel about incurring various levels of risk and how this affects behaviour and decision making. From this point the research and developments entered rapid expansion as more researchers and prominent people within the fields began to take interest in this idea that psychology may play an important role within markets and practitioner behaviour.. In 1973, two psychologists, Amos Tversky and Daniel Kahneman put forth an article and within this paper they “explore[d] a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e., by the ease with which relevant instances come to mind.”(Tversky and Kahneman, 1973, p.207). A heuristic is something that financial “practitioners use [as a] rule of thumb…to process data… they are generally imperfect. Therefore, practitioners hold biased beliefs that predispose them to commit errors.”(Shefrin, 1999, p. 4). This along with the earlier articles and research began to explore in more depth the affects of individuals’ cognitive errors and misjudgements which we now know can lead to market inefficiencies. Then, in 1974, Tverky and Kahneman produced another article with the intention of further developing the field and gaining a more in depth determination of the heuristic identified in their previous paper, within this article they had identified and described three heuristics which can be seen to be in use when making decisions under uncertainty.

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