What Exactly Is Behavioral Finance Essay

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Traditional economics describes human beings as rational decision makers , but it has been observed that investor do not always act rationally. Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient (Sewell, 2001).

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SEWELL, Martin, 2001. Behavioural finance. https://www.behaviouralfinance.net/ . Behavioral finance in recent times become a issue of significant interest to investors because it is a relatively new and evolving field in economics and consequently not well defined, a legitimate question is: “What exactly is behavioral finance?” but it is Described in various ways i.e. Behavioral finance is the integration of classical economics and finance with psychology and the decision-making sciences or an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature or the study of how investors systematically make errors in judgement, or “mental mistakes.” All economic models make simplifying assumptions about both market conditions and the behavior of market participants. Sometimes the simplifying assumptions underlying the model are explicitly stated and sometimes the assumptions are implicit, the latter is often the case regarding the behavioral assumptions underlying the model. To illustrate, consider the efficient market hypothesis (EMH), an economic model of considerable importance to investors. The simplifying assumptions regarding market conditions that underlie the EMH frequently include, among others, assumptions such as: Transaction costs are zero, Markets are not segmented, Easy (even unlimited) entry into the security markets exists. The behavioral assumptions that underlie the Efficient Market Hypothesis can be expressed as: Investors act, in an unbiased fashion, to maximize the value of their portfolios, Investors always act in their own self-interest. The first behavioral assumption is frequently stated as investors are “rational expectations wealth maximizers” this means that investors form unbiased expectations of the future and given these expectations, they buy and sell in the securities markets at prices which they believe will maximize the future value of their portfolios. Behavioral finance questions whether the behavioral assumptions underlying the EMH are true. For example, consider the assumption that individuals always act in their economic self-interest. Suppose you are having dinner at an out-of-town restaurant and it is extremely unlikely that you will ever return to this restaurant. Do you leave a tip? Most people do, but in this case leaving a tip decreases, rather than increases one’s wealth, and because you won’t be returning to this restaurant there are (presumably) no “costs” associated with not leaving a tip.

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