A Literature Study of Behavior Finance and Investor Decision-Making

Abstract

One of the most contentious topics in the development of modern financial economics has been the rationality of financial markets. Conventional finance postulates that investors are rational and impartial, capable of critically assessing the risks and returns associated with investments, and thus making unbiased investment decisions. Nevertheless, as time went on, there were increasing voices from a considerable academic community against the rationality assumption. Among those, behavioral finance has developed to challenge the legitimacy of the rational theory's underlying premises. It has emerged as a field that focuses on studying the actual behavior of investors in financial markets. The paper examines some consensus of traditional financial theories and anomalies in the stock market to introduce prominent cognitive biases influencing people when making investment decisions. It explores emotions behind the cognitive biases and the ways to impact investor behavior and thus gives suggestions about how to reduce errors in financial markets and capitalize on the mistakes of others by adopting an investment strategy that runs counter to common practice.