Behavioral Finance

What is it about?

Behavioral finance studies how psychological bias affects financial decisions and markets. I describe here the basics of why there are judgment and decision biases, how they affect trading and market prices, how mispricing is generated and corrected, the role of wealth flows through trading between more rational and less rational investors, how firms exploit market mispricing and even take actions to incite misvaluation, and how managers are subject to judgment biases, and how that affects the financing, investment, and operating decisions of firms. There is a need for more theory and testing of the effects of feelings on financial decisions and aggregate outcomes. Especially, the time has come to move beyond behavioral finance to social finance, which studies the structure of social interactions, how financial ideas spread and evolve, and how social processes affect financial outcomes.

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Why is it important?

Behavioral finance is a rapidly growing field that has provided a new lens for viewing the economic world. This is an up-to-date overview of this important area.