Most people in the field of finance assume that people act rationally. But research and life experience suggest otherwise, at least some of the time. What are some recent research findings on how our hearts cloud our heads? How can we minimize the irrational parts of our decision making in finance? We need to look at studies in behavioral finance.
By Mark D. Harris, MD, MPH, MBA, MDiv, ThM, PhD, DBA
The Efficient Markets Hypothesis (EMH) suggests that all the available information about a publicly traded company that is pertinent to investing in that company is contained in the stock price at any point in time (Vasileiou, 2020). Insofar as this is true, investors are rational actors who make investment decisions solely on rational grounds. However, company stock prices sometimes are higher or lower than one would expect based on purely objective valuations. This fact suggests that something besides rationality is present in company stock prices.
To explain market behavior beyond the purely rational, researchers turn to behavioral finance. Growing out of Adam Smith’s Theory of Moral Sentiments, one of behavioral finances’ primary observations is that “investors (and people in general) make decisions on imprecise impressions and beliefs rather than rational analysis.” Further, “the way a question or problem is framed to an investor will influence the decision he/she ultimately makes.” The article concludes, “These two observations largely explain market inefficiencies; that is, behavior finance holds that markets are sometimes inefficient because people are not mathematical equations” (Behavioral finance, 2019).
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