Behavioral Finance: Definition & Applications

Instructor: Jason Matyus
Behavioral finance is a new theory that combines behavior psychology with traditional finance theories to determine why people make irrational or rational finance decisions.

Behavioral Finance

As a kid growing up, you may have played pickup games where you divided into two teams, and a captain on each side picked players to be on their team. If things went well, you won most of your games. As games went on all summer, you noticed one particular player who was not quite as tall and could not run as fast. As a result, they were not picked to play on any teams. On a gut feeling, you pick the player and right away, you realize it was a mistake. The player was slow and was not only a liability for your team, but the player's weaknesses turned out to be a help to the other team. You lose game after game, and it is not long before your season is lost. I think at some point in our lives we either experienced this or saw it happen first hand. Behavioral finance works in the same way as the analogy of picking teams. There are instances where wealth builders follow standard protocols for wealth building but sometimes they have a lapse in judgment that turns out to be detrimental to their investments. Other times the gut feeling pays off and the decision turns out to be good. The professionals define behavioral finance as combining behavior psychology with traditional finance theories.

How It Works

There are certain things that act as indicators in the stock market that when they present themselves may present an opportunity. For example, if there is a one-day drop in the price of a stock and there is no good reason such as an earnings report or some bad news coming from a company, it is fair to say it was a false drop. Traditional investors would likely take advantage of the low drop and buy the stock at a low price knowing it would be going back up. Another example may be to buy or sell right before a company's earnings announcement. There have been times historically where there is a rise or decline in a price of stock for no apparent reason. Investors can use many different indicators in business finance.

Behavioral Finance Example

Many factors contribute to the value of a stock going up or down. Traditional finance covers the issue of point prices or external factors that cause stocks to drop or rise. However, there are also other times when a stock goes up or down and it cannot be explained, or more importantly, predicted. Let us suppose for a moment a person died after eating at a major restaurant chain. Investigators trace the death back to the meat, and a lot of money was about to be lost due to investors worried about future problems. Consequently, other investors look at their portfolio and realize they are holding restaurant stock from another chain that purchases their meats from the same supplier. In fear of a major price drop in stocks at other businesses in the food industry, investors sell their restaurant stocks. As a result, the entire industry goes down because of one issue to one supplier. Behavioral finance looks to predict those trends.

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