The Role of Psychological Factors in Behavioral Finance

The Role of Psychological Factors in Behavioral Finance

DOI: 10.4018/978-1-4666-7484-4.ch006
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This chapter introduces the role of psychological factors in behavioral finance, thus explaining the theory of behavioral finance, the application of behavioral finance theory, the empirical achievement in behavioral finance, the utilization of psychological factors in behavioral finance regarding beliefs (i.e., overconfidence, too much trading, optimism and wishful thinking, representativeness bias, conservatism bias, belief perseverance, anchoring, and availability bias) and preferences (i.e., prospect theory and ambiguity aversion). Behavioral finance is a comparatively new management field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide descriptions for why people make unreasonable financial decisions. Psychological factors in behavioral finance hold out the expectation of a better understanding of financial market behavior and scope for investors to make better investment decisions. Applying psychological factors in behavioral finance will tremendously enhance financial performance and achieve strategic objectives in global finance.
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The study of behavioral finance has its roots in cognitive psychology (Sahi, 2012). Cognitive psychology is a branch of psychology that pertains to the understanding of the internal mental processes of thought like visual processing, memory, thinking, learning, feeling, problem solving and decision making, judgment, and language (Sahi, 2012). Cognitive psychology considers emotion to be a product of the cognitive evaluation of an event. Though emotional factors have found to impact the financial decision making in addition to the cognitive limitations that human beings are subject to, these have found to be leading to distortions in cognitions causing biases, that need to be corrected or modified (Pompian, 2006). Behavioral finance models are usually developed to explain investor behavior or market anomalies when rational models provide no sufficient explanations.

Key Terms in this Chapter

Financial Market: A market for the exchange of capital and credit, including the money markets and the capital market.

Investment Strategy: An investor’s plan of distributing assets among various investments, taking into consideration such factors as individual goals and risk tolerance.

Behavioral Psychology: A school of psychology that explains all mental and physical activities in terms of response by glands and muscles to external factors.

Financial Industry: The part of an overall economy that is primarily made up of money markets, banking institutions, and brokers.

Behavioral Finance: A theory stating that there are psychological and behavioral variables involved in investing in the stock market that provide opportunities for smart investors to profit.

Resource Allocation: The process of allocating resources among the various projects or business units.

Finance: A branch of economics concerned with resource allocation as well as resource management, acquisition, and investment.

Stock Market: The general term for the organized trading of stocks.

Investor: An individual who commits money to investment products with the expectation of financial return.

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