Improving the Quality of Decision Making for Investors: A Research under Behavioral Finance and Psychology

Abstract

Behavioral finance theory emerged as a response to concerns and shortcomings in existing financial theories, such as the Efficient Market Hypothesis (EMH) and the Capital Allocation Pricing Model (CAPM), by incorporating elements of human psychology and behavior into the framework of finance research. The major difference between behavioral finance and classical financial theory (such as CAPM and EMH) lie in their assumptions and interpretations of investor behavior, particularly on whether investors are indeed rational or not. To deal with these crucial issues that behavioral finance raises, investors must first acknowledge the presence of these issue, understand the notion of them and how they influence decision-making, and be aware that their decisions may alter depending on the source and use of money. This paper aims at understanding the key crucial concepts of behavioral finance and presenting several ways to deal with the behavioral finance related issues. Loss aversion, overconfidence and mental accounting will be examined in detail in this paper to explore the reason behind these phenomenon and present ways to deal with these issues.