Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Behavioral Finance

What it is:

Behavioral finance combines social and psychological theory with financial theory as a means of understanding how price movements in the securities markets occur independent of any corporate actions.

How it works (Example):

Suppose a lawsuit is brought against a tobacco company. Investors know that when this has happened before, the share price of the tobacco company has fallen. With this in mind, many investors sell off their holdings in the company. This selling results in the further decline of the security's value.

Investors in other tobacco companies may fear similar lawsuits knowing that such a lawsuit was brought against one tobacco company. These investors may sell off their holdings for fear of loss. The securities prices of other companies in the industry consequently decline as well.

All the while, none of these tobacco companies took any action or had a judgment against them that intrinsically lessened their worth. This is the sort of issue that behavioral finance attempts to explain.

Why it Matters:

Anyone knowledgeable in financial market understands that there are numerous variables that affect prices in the securities markets. Investors’ decisions to buy or sell may have a more distinct margin affect impact on market value than favorable earnings or promising products.

The role of behavioral finance is to help market analysts and investors understand price movements in the absence of any intrinsic changes on the part of companies or sectors.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...