Behavioral Finance

“Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system.” (“How Did Economists Get It So Wrong?”, Krugman) Behavioral finance is a newer theory in which more economist are starting to use since the great recession. It is the study of how human psychology, such as our thoughts, attitudes, and feelings, influence financial decisions. Behavioral finance combines both classical economic theories with psychology to understand and create the changing thought patterns and modes of doing business that can bring a crisis. Economists who follow this model do not only consider the effects of market decisions but also focus strongly on public choices and how they react and feel. Before the recession, this way of thinking was rarely used. “Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance.” (“How Did Economists Get It So Wrong?”, Krugman)  Behavioral finance emphasizes on the inefficiencies and the different reactions to information as causes to different market trends such as crashes. It is very important when the market is unstable, which it often is. I feel if economist viewed things through a behavioral finance lens, the economy could have been a little more prepared and would have been more efficient in damage control.