Upon the advent of prospect theory by two psychologists Daniel Kahneman and Amos Tversky (1979), the world of economics and finance has not been the same. Contrary to prevailing beliefs, their theory suggested that individuals make systematic psychological errors and that the assumption of rational expectation is plainly bazar. This would inspire countless of experiments and papers as evident from their citation count being north of 70,000 (as per Google Scholar). In fact, work in this field was so profound that, except for the untimely passing of Tversky, they would have both been awarded the Nobel Prize in Economics.
Given the severe implications of these theories and ideas on the field of economics, the same ideas undoubtedly permeated the field of finance giving birth to another field, aptly named, Behavioral Finance. According to Dr. David Hirshleifer, who became President elect of the American Finance Association as of 2018, “behavioral finance studies the application of psychology in finance” (2015). It builds upon the theories set forth by Kahneman and Tversky and begs for the collision between the world of modern psychology and finance. Furthermore, if one believes that the financial markets are just a product of people’s interactions and willingness to buy and sell, then the thought that psychology may be a useful tool to better understand markets seems like a rather obvious one.
Today, there are plenty of people advancing the field of behavioral finance. Be it, investor expectations, biases, or even psychological weaknesses to manipulation, the fundamental belief is that people move markets, and understanding people is crucial to fully understanding markets. In fact, in a piece discussing Behavioral Finance in the Annual Review of Financial Economics, Dr. Hirshleifer makes the point that time has come for the transcendence of behavioral finance to social finance. Afterall, markets are not made up on individuals interacting with themselves, but rather a complex network of transactions and communication between all kinds of social groups.
Bibliography
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263–291. https://doi.org/10.2307/1914185
Hirshleifer, D. (2015). Behavioral finance. Annual Review of Financial Economics, 7, 133-159.
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