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During the 1970s and early 1980s, researchers found sufficient evidence that the
financial markets are efficient and that investment decisions are taken rationally. However, over
the last few decades, there have been major challenges to this finding. Such challenges,
coming from the behavioral finance side, continue to advance the argument that the
traditional finance theory's predictive power is not sufficient to explain what investors observe
and experience in the markets in reality. It has been well established that investor
behavior and asset price deviate from the predictions of simple rational models. During the past
30 years, behavioral finance has become one of the most active areas in
financial economics. Researchers across the world are trying to understand the interaction
of psychology and finance to develop models and theories to have a deeper and
better understanding of the investment decision making process of the investors.
The proponents of behavioral finance believe that individuals in investment
markets do not always act as rational entities. Their emotions and behavioral biases lead
to systematic errors in the manner in which they process information to take
investment decisions (Pavabutr, 2002). Their investment decisions are guided by their desires,
goals, prejudices and emotions. The literature on behavioral finance has been able to
establish that investors often exhibit behavioral biases such as overconfidence, self-attribution
bias, framing effect, reference dependence, loss aversion, over- and under-reaction, etc.,
which distort their investment decision making. |
