Loss Aversion & Mental Accounting – A Behavioral Finance Perspective

Abstract

A new field in finance evolved in the 1980s; one which did not build on fundamental basis but from the world of psychology, known Behavioral Finance. The theories in Behavioral Finance also presented a new point of view when explaining market movements. The market is determined by people who cannot always be considered rational in their investment choices, especially not during times of financial agony. Behavioral finance is, in fundamental nature, trying to elucidate and increase understanding of the reasoning patterns of market members, including the emotional course of actions involved and the degree to which they influence the decision-making process. This report takes the perspective to investigate the psychological impact on investors in the financial world. Behavioral Finance Behavioral Finance considers different psychological behavior of individuals and how these traits affect how they act as investors, analysts, and portfolio managers. Noted by Olsen, behavioral finance recognizes that the standard finance model of rational actions and profit maximization can be true within specific limitations, but advocates of behavioral finance state that this model is incomplete since it does not think about individual behavior. In particular, behavioral finance seeks to understand and forecast systematic financial market implications of psychological judgment processes. Behavioral finance is focused on the implication of psychological and economic principles for the enhancement of financial decision making, while it is accepted that at present there is no integrated theory of behavioral finance, the emphasis has been on identifying portfolio anomalies that can be explained by a variety of psychological traits in individuals or groups or analytical instances where it is possible to get above-normal rates of return by exploiting the biases of investors, analysts or portfolio managers.