Behavioral Finance Behavioral finance is a field of study that proposes psychology-based theories to explain stock market anomalies. Proponents argue that investors are not nearly as rational as traditional finance theory makes them out to be. Of course, the idea that psychology drives stock market movements flies in the face of the efficient market hypothesis. In fact, behaviorists, as they are called, contend that, rather than being unusual, irrational behavior is commonplace. Here is one of the experiments they cite to support that view.

Suppose you are given a choice of a sure $50 or a coin flip in which you could win either $100 or nothing. Most people, being risk averse, would pocket the sure $50. Now, suppose you are confronted with this choice: a sure loss of $50 or a coin flip in which you could lose either $100 or nothing. Now, most people would choose the coin toss, although the value inherent in flipping the coin is equivalent in both scenarios. The idea here is that people tend to view the possibility of recouping a loss as more important than the possibility of greater gain. The priority of avoiding losses also affects investor behavior. It is common for investors to watch a particular stock plummet in value but refuse to sell because it would lock in the loss coupled with the belief that the price will eventually bounce back to the value it had once achieved.

Although behavioral finance offers no investment miracles, perhaps it can help investors train themselves to watch their own behavior and, in turn, avoid mistakes that would be detrimental to their personal wealth. What are your views on behavioral finance? Is there anything to it? Does it make more sense than market efficiency? Do you believe that knowledge or behavioral finance can help you beat the market?