Put Your Money Where Your Mind Is: An Introduction to Behavioural Finance
Things on paper and in theory, normally run smoother than they do in reality, don’t they?!
Hence the untameable nature of the tumultuous stock market, ever enticing, ever rewarding, and ever frustrating, all at the same time.
Countless theories seek to maximize returns from investments, but while considering each person as a homo economicus: a financial being whose inherent tendency to maximize wealth will lead him to make the most rational of decisions.
Uh, right. Again: paper and theory vs. reality.
And that’s where behavioural finance comes in.
Investopedia.com defines it as “a relatively new field that seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.”
According to behavioural financiers, theories such as the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) – both of which we’ll see more of in later posts – don’t account for anomalies (irrational financial decisions), such as the January Effect, the Equity Premium Puzzle, or the Winner’s Curse.
We’ll be looking at all of those anomalies and key concepts in greater detail a little later on, so let me give you a quick synopsis of one of them to give you a better idea as to what I’m talking about.
The Winner’s Curse is a look at the human being’s attribution of value to a certain good, and how that attribution can be affected by the aggressiveness and number of other bidders seeking to acquire that same good. The perfect example is the purchase of a home. Consider the fact that every person bidding for the house is rational, and has done her studying by comparing recent sales of similar homes in the area. Nevertheless, the aggressiveness and amount of bidders looking to buy that one, exact, same house can oftentimes cause a valuation error, driving the sales price up 25% above the home’s true value.
And so, what’s the purpose behind this blog?
- To serve as the best possible source for the history, and current breakthroughs of behavioural finance.
- To explain the key concepts of behavioural finance, to introduce the main proponents of the theories, as well as their opponents.
- To explore both the irrational behaviour that the science is trying to explain, as well as proposals for improving and correcting that behaviour.
Thanks for reading, and stay tuned.