Behavioral finance is a branch of economic studies that, as the term itself suggests, studies the behavior of investors. The theories of behavioral finance are based on principles of psychology that analyze social and individual behavior.
Behavioral finance studies examine the ways in which traders act. Their actions are in fact reflected in the market and being able to understand their psychological mechanisms is important to understand how they will move in investments.
Behavioral finance theories begin with Adam Smith, who in his text Theory of moral sentiments, analyzes individual psychological behavior. Neoclassical economics will then distance itself from behavioral finance theories, seeing man as efficient and not guided by emotions.
Behavioral finance theories will return to favor in 1979, when Decision Making Under Risk, by Daniel Kahneman and Amos Tversky, is published.
Khneman and Tversky’s manual explained with some postulates of cognitive psychology some anomalies that occurred on the markets in the period preceding its publication. This will become one of the fundamental texts of behavioral finance, leading it to definitively become a branch of economic studies.
The fundamental points of behavioral finance studies are 3: heuristics; framing and market inefficiency. Heuristics analyzes how the person’s past experiences influence future decisions; the framing instead shows how the way of posing a certain question changes the investor’s decisions.
The other great point of behavioral finance is market inefficiency, which analyzes situations contrary to empirical explanations and theories.
Some traders place a lot of trust in behavioral finance and consider it a real way to understand market changes. Behavioral finance seeks to fill the gap between the lack of perfect rationality of investors and the structure of the market and all the information that concerns it.
To learn more, read Behavioral finance: what it is and what are the best books to learn about it
