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Impact of Psychology on Finance

August 17th, 2009 Leave a comment Go to comments

For all their flair and boasted smugness, traders are not nearly as rational as they claim to be. This principle, which is in open conflict with the conventional Efficient Market Hypothesis supported by Modern Finance, is at the heart of a new discipline called behavioral finance. These studies target the cross-territory between psychology and finance and have an impressive body of empirical evidence supporting their statements.

What are the most common human frailties preventing the rational decision-making postulated by modern finance theory and conventional economics at large ?

1) Overconfidence, whereby humans do not know what they do not know and widely overstate their own information gathering and analysis capabilities. Illusion of control and a variety of self-attribution biases fall in this category.

2) Prospect theory, which states that human decisions are affected by psychological reference points. For instance, someone who is in a losing position will likely try to get even, whereas someone in a winning position will more likely try to secure his or her gains.

3) Anchoring and a variety of other biases in making projections about how current situations may evolve in the future. Typically, individuals tend to extrapolate too much from existing trends or, at the opposite extreme, tend to underweigh base rate information about changes in the trend when this information conflicts with the previously-held view.

Both laymen and professionals are affected by these biases. Serious financial trading losses are not suffered only by ordinary investors. LTCM, Metallgesellshaft and Barings are only a few of the notorious names of financial disasters that made the headlines during the 1990’s.

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