Behavioral Finance

The most exciting advancement in financial theory over the past 25 years is the formulation of Behavioral Finance. Behavioral Finance reflects the reintegration of human psychology into decision-making. In contrast to decision models from Classical and neoclassical Finance, where emotions were stripped away leaving a strictly rational, profit maximizing decision maker, Behavioral Finance recognizes that people often make choices that "feel right" but may not be financially optimal. Research has identified broadly observable mental traps that often lead to non-optimal financial decisions. The most commonly observed traps are: heuristics (rules-of-thumb that often are untested), biases (preferences independent from facts), over confidence (learning without analytic support) and framing (choices influenced by presentation over facts).

The academic literature categorizes non-optimal decisions into specific financial behaviors. The Disposition Effect (selling winners in preference to losers), Anchoring (the tendency to hold on to previously established ideas or opinions – such as the target price for selling a stock), Contra-positive Investing (allowing previous experience with a stock to influence reinvestment) and Hindsight Bias (using memory rather than analytics to evaluate past judgments) are examples of well documented investor behaviors reflecting the mental traps above. Research focusing specifically on the investment behaviors of institutional investors has exploded in recent years. While better informed, more experienced and supported by better analytic technology than their retail counterparts, institutional investors nevertheless do succumb to behavioral tendencies – certainly at the margin.

For more information on Behavioral Finance, refer to this list of suggested readings.