Behavioral Finance: How Psychology Affects Investment Decisions

Abstract

Behavioral finance examines how psychological factors affect investment choices and financial markets, violating the standard economic theories that rely on rational behavior. Behavioral finance blends knowledge from psychology and finance in order to comprehend why investors tend to make irrational choices that do not follow rational models. Emotions, cognitive biases, and social influences affect decision-making procedures, resulting in systematic errors including overconfidence, loss aversion, and herd behavior. Investors can overreact to information, misjudge risk, or retain losing investments because of psychological biases. This action creates market inefficiencies and departures from the efficient market hypothesis. Being aware of these psychological forces allows investors and financial professionals to make more sound decision-making approaches, mitigate risks, and sidestep trapdoors. Behavioral finance highlights the need for awareness and utilization of tools to reduce bias, for example, by diversifying a portfolio and using rules-based strategies. Through linking psychology and finance, behavioral finance provides insights into refining market outcomes as well as the behavior of investors.