Keith Redhead, PhD
Behavioral finance brings psychological and sociological considerations to bear on the analysis of financial decision-making. When considering decision-making, the behavioral influences can be classified as heuristic simplification, self-deception, affect, and social influence. This chapter explains and illustrates some of the behavioral finance concepts and shows their relevance to the practice of financial planning and advice.
Heuristic simplification becomes necessary because of bounded rationality, which is rationality that is limited by intellectual capacity. Nobody is capable of absorbing and analyzing all available information. The mind has limited capacity, and it deals with this limitation by using heuristic simplification in the form of mental shortcuts and rules of thumb. The heuristics produce psychological biases that appear to be universal and hard-wired into our brains. Some have even been found in other primates, indicating a distant evolutionary origin. It has been suggested that there may be as many as 150 psychological biases arising from heuristic simplification. The following are a few of them.
The Availability Bias is the tendency to give most attention to information that is easily recalled when making a decision. Information that is repeated, vivid, emotion-inducing, or personal will have the strongest influence ...