The key principles of behavioral finance are:
1. Investor bias: Investors are subject to various cognitive and emotional biases that can impact their decision-making, such as overconfidence, anchoring, herding behavior, and loss aversion.
2. Market inefficiencies: Markets are not always efficient and may be susceptible to pricing anomalies or bubbles, and can lead investors to make irrational decisions.
3. Prospect theory: Prospect theory suggests that people’s decisions are influenced by potential gains/losses, rather than the actual outcome, and it can impact investment decision-making.
4. Mental accounting: People tend to categorize funds based on the source, purpose, or expected use, and this can lead to suboptimal decision-making.
5. Limited attention: Investors have limited attention, and may not be aware of all the information needed, leading to suboptimal decision-making or missed opportunities.
These principles can impact financial decision-making in various ways. For example, overconfidence can lead investors to take on more risk than they should or underestimate the potential downside of an investment. Herd behavior can lead investors to follow the crowd and invest in popular assets, even if they are overpriced. Mental accounting can lead investors to end up with suboptimal investment portfolios. Limited attention can lead to missed opportunities or the inability to make informed decisions. Overall, behavioral finance highlights the importance of understanding how behavioral biases and market inefficiencies can impact investment decisions, and the importance of seeking to overcome these biases to make more rational, informed investment decisions.
