What is Behavioral Finance?

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In classical finance, traders and investors should always make rational decisions to maximise their self-interests, but in practice, quite often they end up making decisions that are not always rational, due to the influence of emotions and cognitive biases.

There is a whole (relatively new field) of finance called behavioral finance, which seeks to understand why this happens.

Behavioral finance is the branch of finance that combines classical finance (rational decision-making) with the psychological/behavioral aspect of market participants.

In layman terms, classical finance tells us what people should do, whereas behavioral finance tells us what people actually do.

The main reason for this difference is that classical finance assumes that humans are rational decision-making robots, but in reality humans are subject to emotions, flawed thinking, cognitive biases, etc.

If you have tried trading in the markets, or even played a game of chance like poker, you will know how hard it is to make rational decisions once money is at stake, and greed and fear starts to cloud your judgement.

 

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