Behavioral finance

An increasingly fashionable field of study to explain how financial markets work. Essentially, behavioral finance tries to put people back into the equation. Much of the influential academic work of the 1950s and 1960s assumed that market prices were determined by profit-seeking individuals acting rationally. However, this work, which generated portfolio theory and the efficient market hypothesis, could not explain many of the pricing anomalies that regularly crop up (for example, see calendar effect and small cap stock). Behavioral finance tackles these issues by applying the methods of behavioral psychology to investors' behavior. In particular, it takes the rules of thumb that people use in everyday life to make judgments under conditions of uncertainty and examines their shortcomings from the point of view of probability theory. Such rules of thumb fall into three main categories.

Representativeness. People make consistently poor predictions when they think that an instance is representative of a wider category. For example, the more favorable the description of a company, the more likely it is that investment analysts will forecast good profits growth and a high price for its shares because favorable descriptions imply success. They ignore the point that a forecast does not become more accurate as the description on which it is based becomes more favorable.

Availability. People draw conclusions faster and more confidently the more readily they can recall similar instances. For example, they believe that the chance of a stock market crash is much greater than statistically likely if there has been a recent crash that springs to mind.

Anchoring and adjustment. People make predictions by adjusting an initial calculation, but too often they make insufficient adjustment. For example, when estimating the likelihood that a company can bring a new product to market, analysts are often too optimistic. They underestimate the sequence of events that must be successfully negotiated. Even if the probability of success at each stage of the process is high, the overall probability of success will be lower and will decline the more stages that have to be passed.