Behavioral finance, a relatively new area of financial research, has been receiving more and more attention from both individual and institutional investors. Behavioral finance combines results from psychological studies of decision-making with the more conventional decision-making models of standard finance theory.
By combining psychology and finance, researchers hope to better explain certain features of securities markets and investor behavior that appear irrational. Standard finance models assume that investors are unbiased and quite well informed. Investors are assumed to behave like Mr. Spock from Star Trek, taking in information, calculating probabilities and making the logically “correct” decision, given their preferences for risk and return. Behavioral finance introduces the possibility of less-than-perfectly-rational behavior caused by common psychological traits and mental mistakes.
Six common errors of perception and judgment, as identified by psychologists, are examined in this article. Each has implications for investment decision-making and investor behavior. An understanding of the psychological basis for these errors may help you avoid them and improve investment results. And in some cases, market-wide errors in perception or judgment can lead to pricing errors that individuals can exploit. Understanding the psychological basis for the success of momentum and contrarian strategies can help investors fine-tune these strategies to better exploit the opportunities that collective mental mistakes create.