Categorized | Behavioral Economics

Behavioral Economics: What You Should Know

Behavioral economics is related to behavioral finance and the concept examines the effects that emotional, cognitive and social factors has on both individuals and institutions’ economic decisions, as well as the consequences for returns, market prices and resource allocation. The concept is basically about the bounds of economic agents’ rationality. Behavioral finance or economics also looks into the manner in which market decisions are made, as well as the instruments that influence people’s choice.

The Prevalent Themes in Behavioral Economics

In behavioral economics, three themes are prevalent as follows:

• Market Inefficiencies: Typical example is mis-pricing as well as irrational decision making.

• Framing: This refers to the collection of stereotypes and anecdotes contained in the emotional filters used by individuals in understanding and responding to trends or events.

• Heuristics: It simply means people usually base their decisions on estimated rules of thumb instead of going through a logical conclusion.

What are the Issues Arising from Behavioral Economics?

In behavioral economics, the central issue is why market and investment participants fall into systematic errors in converse to what the rational market participants assume. The systematic errors in question affect both price and returns, which in turn facilitates market inefficiencies. Behavioral finance is also concerned with the way other participants turn such market inefficiencies to their own benefits – something known as arbitrage.

Behavioral finance also emphasizes that over-reactions and under-reactions to information, as well as other inefficiencies are responsible for market trends (and sometimes bubbles and crashes). Some of the factors that have been linked to such reactions include overconfidence, limited investor attention, herding instinct (mimicry), over-optimism as well as noise trading.

Herding and group think are also very critical when it comes to behavioral economics. These simply refer to the scenario where people move towards a popular trend, reasoning as a group rather than take individual decisions. In such scenario for instance, people dispose their stocks and put their accounts in red just hearing about a possible financial decline. This will likely kick-start a panic and others will join the bandwagon to the detriment of the economy.

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