The study of the role played by psychological factors in financial decision making and hence their effect on overall market outcomes. In particular, behavioral finance studies the ways in which individual and group behaviour deviates from the rational pursuit of self-interest posited by classical economic theory (see bounded rationality). A range of cognitive and emotional biases affecting decision making in conditions of uncertainty have been identified: these include systematic errors of judgment in estimating probability, the tendency to underreact to new information and then to ‘compensate’ by overreacting, and the unwillingness to realize a nominal loss (e.g. by selling shares that have fallen in value). Behavioral finance holds that such biases may create significant market anomalies, especially when they become self-reinforcing within a social group (e.g. in cases of panic selling). See also prospect theory; risk preference.
Subjects: Financial Institutions and Services.