Behavioral Finance and Wealth Management

Behavioral Finance Explained

Behavioral finance focuses on the psychology of financial decisions. It takes issue with some fundamental assumptions of conventional finance, especially the notion that markets are efficient and investors are rational. In an efficient market, securities prices supposedly reflect all relevant information so rapidly that no investor can hope to beat the market average over the long term. Prices move as new information emerges and traders quickly take advantage of any mispricing.

This conventional financial thinking leaves no room for irrational market behavior. It assumes that prices reflect everything known or knowable about value. Yet, persistent anomalies show that investors do indeed act somewhat irrationally. For example, investors consistently overprice growth companies and underprice unfashionable companies. In fact, the value style of investing depends on this anomaly. For other investors, timing is everything. For example, they may believe strongly in the January effect, a term that refers to the fact that stock returns in January tend to be high because people sell stock in December to generate tax-deductible losses.

Economists...