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.