Behavioural Finance
What Behavioural Finance Studies
How behavioural finance combines psychology and finance to explain investor mistakes and market puzzles that traditional theory struggles with.
Traditional finance theory assumes investors are rational: they process information correctly, avoid predictable mistakes and push prices to their fair values. This leads to the efficient market hypothesis, which says prices reflect all available information.
Behavioural finance asks what happens when these assumptions fail.
Two building blocks
- Investor psychology: real people have biases. They fear losses, trade too much, follow crowds and overreact or underreact to news.
- Limits to arbitrage: in theory, smart investors should correct mispricing by buying cheap assets and selling expensive ones. In practice, this can be risky, costly or impossible, so mispricing can last.
When both hold, market prices can drift away from fundamental values.
Key figures
- Daniel Kahneman and Amos Tversky developed prospect theory, explaining how people treat gains and losses.
- Richard Thaler applied psychology to economics and finance, winning the Nobel prize in 2017.
- Robert Shiller showed stock prices swing more than dividends justify, sharing the Nobel prize in 2013.
What it explains
- Why many individual investors underperform simple index funds.
- Why bubbles and crashes happen.
- Why some investment strategies, called anomalies, seem to earn higher returns than theory predicts.
A balanced view
Behavioural finance does not say markets are easy to beat. Even when prices are wrong, it is hard to know when they will correct. Many professional investors fail to beat the market after costs. The practical lesson for most people is to understand their own biases and build habits that protect them.
In March 2020, as markets crashed during the pandemic, many investors sold their shares in fear. Markets recovered strongly within months. Those who sold near the bottom locked in losses, not because of new information about companies, but because of fear.
Knowing that prices can be wrong doesn't tell you when they will correct. Most investors still do better with simple, low-cost strategies.
- Behavioural finance combines psychology with finance.
- Investor biases and limits to arbitrage allow mispricing to persist.
- It helps explain underperformance, bubbles and anomalies.
- Its main practical lesson is to understand and manage your own biases.
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