"Behavioral Finance is the study of the influence of psychology on the behavior of investors or financial analyst. It assumes that investors are not always rational, have limits to their self-control and are influenced by their own biases. For example, behavioral law and economics scholars studying the growth of financial firms’ technological capabilities have attributed decision science to irrational consumer decisions. It also includes the subsequent effects on the markets. Behavioral Finance attempts to explain the reasoning patterns of investors and measures the influential power of these patterns on the investor's decision making. The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants. Such errors affect prices and returns, creating market inefficiencies.
The accepted theories of finance are referred to as traditional finance. The foundation of traditional finance is associated with the modern portfolio theory (MPT) and the efficient-market hypothesis (EMH). Modern portfolio theory is a stock or portfolio's expected return, standard deviation, and its correlation with the other stocks or mutual funds held within the portfolio. With these three concepts, an efficient portfolio can be created for any group of stocks or bonds. An efficient portfolio is a group of stocks that has the maximum (highest) expected return given the amount of risk assumed, contains the lowest possible risk for a given expected return. The efficient-market hypothesis states that all information has already been reflected in a security's price or market value, and that the current price of the stock or bond always trades at its fair value. The proponents of the traditional theories believe that 'investors should just own the entire market rather than attempting to outperform the market'. Behavioral finance has emerged as an alternative to these theories of traditional finance and the behavioral aspects of psychology and sociology are integral catalysts within this field of study.
The foundations of behavioral finance can be traced back over 150 years. Several original books written in the 1800s and early 1900s marked the beginning of the behavioral finance school. Originally published in 1841, MacKay's Extraordinary Popular Delusions and the Madness of Crowds presents a chronological timeline of the various panics and schemes throughout history. This work shows how group behavior applies to the financial markets of today. Le Bon's important work, The Crowd: A Study of the Popular Mind, discusses the role of "crowds" (also known as crowd psychology) and group behavior as they apply to the fields of behavioral finance, social psychology, sociology, and history. Selden's 1912 book Psychology of The Stock Market was one of the first to apply the field of psychology directly to the stock market. This classic discusses the emotional and psychological forces at work on investors and traders in the financial markets. These three works along with several others form the foundation of applying psychology and sociology to the field of finance. The foundation of behavioral finance is an area based on an interdisciplinary approach including scholars from the social sciences and business schools. From the liberal arts perspective, this includes the fields of psychology, sociology, anthropology, economics and behavioral economics. On the business administration side, this covers areas such as management, marketing, finance, technology and accounting.
Critics contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies are either quickly priced out of the market or explained by appealing to market microstructure arguments. However, individual cognitive biases are distinct from social biases; the former can be averaged out by the market, while the other can create positive feedback loops that drive the market further and further from a "fair price" equilibrium. It is observed that, the problem with the general area of behavioral finance is that it only serves as a complement to general economics. Similarly, for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case for many anomalies. A specific example of this criticism appears in some explanations of the equity premium puzzle. It is argued that the cause is entry barriers (both practical and psychological) and that the equity premium should reduce as electronic resources open up the stock market to more traders. In response, others contend that most personal investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials."