Behavioral Finance- An Appraisal

Behavioral Finance seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.

One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational “wealth maximizers” who seek to increase their own well-being amplifying the fact that emotions and other extraneous factors do not influence people when it comes to making economic choices.

The fact is people frequently behave irrationally. Thus putting theories like Capital Asset Pricing Model and Efficient Market Hypothesis ineffective.

The presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioral finance and their continued existence which directly violate modern financial and economic theories. The normal analogies are:

• January Effect: The January effect is named after the phenomenon in which the average monthly return for small firms is consistently higher in January than any other month of the year.

• The Winner’s Curse: One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of some asset and will bid or pay accordingly. But at times in an auction, the bidder aggressively exceeds the price he is ready to pay for an asset (more than the asset is worth) just to be the winner at the auction.

• Equity Premium Puzzle: In the past century, equity has paid an average return of 6% per annum to its investors, thus making Equity a good investment option even for risk averse investors and down falling investment in Bonds which has paid in between 3-4% returns annually in the past.

Behavioral finance is the key reason accounting for systematic and non systematic errors which infect the calculative and numerical characteristic of finance. It is beyond the calculation by the Analysts and deviate the results from the expected ones. Thus an intelligent investor must take into consideration the behavioral or say the irrational aspect of financial decision making and make room for adequate mitigation facility to minimize risk or moderate the losses.

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