Overview

Traditional finance assumes investors are Spock (rational). Behavioral finance knows they are Homer Simpson (emotional). It explains why we panic sell at the bottom and buy FOMO at the top.

Core Idea

Loss Aversion: The pain of losing $1,000 is twice as intense as the joy of gaining $1,000. This leads investors to hold onto losing stocks too long (hoping to break even) and sell winning stocks too soon (to lock in a gain).

Formal Definition (if applicable)

Herding: The tendency for individuals to mimic the actions (rational or irrational) of a larger group. (e.g., The Dot-com bubble, Bitcoin mania).

Intuition

  • Overconfidence: “I can pick stocks better than the pros.” (Most people can’t).
  • Recency Bias: “The market has been going up, so it will keep going up.”
  • Confirmation Bias: Reading only news that agrees with your investment thesis.

Examples

  • Tulip Mania (1637): People sold houses to buy tulip bulbs.
  • 2008 Crisis: Everyone believed housing prices could never fall.
  • GameStop Short Squeeze: Social sentiment driving prices.

Common Misconceptions

  • “You can exploit these biases to get rich.” (Hard to do consistently. “The market can remain irrational longer than you can remain solvent.”)
  • Nudge: Designing 401(k)s to auto-enroll employees because people are too lazy to sign up.
  • Mental Accounting: Treating money differently depending on where it came from (spending a tax refund on a vacation but saving a paycheck).

Applications

  • Financial Advising: Managing client emotions.
  • Trading Strategies: Momentum investing.

Criticism / Limitations

It explains past anomalies well, but doesn’t always predict future ones.

Further Reading

  • Thaler, Misbehaving
  • Kahneman, Thinking, Fast and Slow