Behavioral Finance

Introduction

Behavioral finance is a subtopic of the broader subject of behavioral economics. The behavioral in the name means that the behavior of participants in the actual economy is fundamentally different than what most academic theorizing normally assumes. Behavioralists argue that the predictions of economics, finance in particular, must be modified to account for how people actually behave in economic situations.

What is “commonly assumed” in economics and finance? The answer, in a word, is rationality. The usual implementation of rationality is to assume that individuals in the economy have a utility function that serves as a guide to what makes them happy, happier, and less happy. That utility function values various choices that a person could make subject to wealth, income, or whatever constrains expenditures for a particular person. The rational person maximizes utility (satisfaction, happiness, whatever the utility function is presumed to measure), staying within the bounds of what is possible as constrained by wealth and liquidity.

The utility-maximizing exercise by agents (persons, businesses, etc.) leads to predictable behavior and provides predictions about how markets function in the real world. For example, rational behavior by individuals, along with some other assumed conditions, implies that resources are allocated efficiently by the price mechanism both for the broader economy and for financial markets in particular. Prices perform a signaling function ...