The first attempts to analyze and explain the actions of economic agents from the psychological perspective were made in the 18th century. Since then, this field of study has advanced substantially. The ideas on behavioral economics can be found in the works of the representatives of the different schools. Many of them are devoted to the specific field of study, Behavioral Finance.
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Economics is the sphere of study, which is mostly based on the model ignoring the psychological aspects of the economic agents’ behavior. In contrast, Behavioral Economics recognizes the importance of cognitive biases in the context of economic decision-making (Thaler & Mullainathan n.pag.).
“As long ago as 1841, Charles Mackay in his influential book Memoirs of Extraordinary Popular Delusions described the famous tulipmania in Holland in the 1630s, a speculative bubble in tulip flower bulbs” (Shiller 91-92). At that time, the market fell drastically and never rose again to the previous levels after the bubble burst.
Behavioral Finance is the major field of Behavioral Economics focus. The scholars specializing in this field try to explain the dynamics of the financial markets from the standpoint of the investors’ moods and perceptions, and their influence on the overall market trend. The specialists in the Behavioral Finance claim that the investors dislike losses more than they like the returns. That is, their risk aversion is asymmetrical.
This idea makes the Behavioral Finance theory substantially different from the postulates of the traditional economic theory. Also, the new theory is closely related to the Efficient Markets Hypothesis proposed by Eugene Fama. “The EMH does not assume that all investors are rational, but it does assume that markets are rational” (Ritter n.pag.).
The irrationality of the investors’ decisions is one of the main postulates of Behavioral Finance. In contrast to the efficient market theory, it claims that the marker inefficiencies exist due to the irrational behavior of the investors, and, thus, the abnormal economic profits can be earned.
In summary, Behavioral Finance is the modern branch of the economic theory, which explains the market situation based on the investors’ behavior. I think that the postulates of the theory are supported by an adequate scientific background. In my opinion, it is valid for economic decision making. At the same time, it should be used together with other investment analysis applications to have a broader vision of the examined market trends.
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Daniel Kahneman was the Noble Prize winner in Economics in 2002 (“Speakers Daniel Kahneman” n.pag.). He was awarded the Prize for the achievements in the field of Behavioral Economics.
The works of Kahneman are devoted to the problems of the economic agents’ behavior with the particular focus on their cognitive biases leading to irrational decisions. Kahneman was awarded the Prize together with his co-author Twerski, who died before their work won the Prize (“Speakers Daniel Kahneman” n.pag.).
The authors studied the problem of the economic agents’ behavior in the context of their attitude to risk. The scholars made a significant contribution to the explanation of the people’s behavior under the conditions of uncertainty.
They argued that the economic agents were driven by their cognitive biases in the process of making economic decisions. Therefore, their judgments, which were subjective, contributed to the irrationality of the markets.
Ritter, Jay R. “Behavioral Finance.” Pacific-Basin Finance Journal 11.4 (2003): 429-437. Print.
Shiller, Robert J. “From Efficient Market Theory to Behavioral Finance.” Journal of Economic Perspectives 17.1 (2003): 83-104. Print.
“Speakers Daniel Kahneman: Behavioral Economic Founder”. Ted.com. March 2010. Web. 28 Nov. 2013.
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Thaler, Richard H. and Sendhil Mullainathan. “How Behavioral Finance Differs from Traditional Economics.” Econlib.org. 2008. Web. 28 Nov. 2013.