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.

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3 Responses to Behavioral Finance

  1. ALXLIONS says:

    I think using a behavioral finance is good when looking at the past but isn’t as effective when trying to analyze the future. I feel like people will react differently to different situations and this will affect the economy. No two situation is the exact same so it would be hard to apply someone’s previous actions to the future. For example, two different natural disasters could affect someone in two completely different ways depending how much they are actually affected by it.

  2. KCasty says:

    Behavioral finance seems like a very interesting topic, and one that is important to consider when looking into peoples’ financial decisions as well as overall economic trends. There can be innumerable economic models and theories that are consistently accurate, but there are other factors that go into the economy and peoples’ financial decisions that can not be accounted for in these models and theories. I think behavioral economics is something that should be discussed in more finance and economic classes so that students remember these extra factors that need to be taken into account. The fact of the matter is that peoples’ emotions play into the decisions that they make most (if not all) of the time, whether it is consciously or subconsciously — it is definitely beneficial to understand behavior with regard to financial decisions.

  3. I definetely agree, Katie, that behavior should be considered in economics. This is what, in my opinion, brings an economical theory from theoretical to more practical. How can one honestly create a model that describes human patterns/decisions without taking into consideration our behavior?

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