Behavioral economics explores how individuals make financial decisions from "summary" of Economics of Money, Banking and Financial Markets, Business School by Frederic S. Mishkin
Behavioral economics seeks to delve into the intricacies of how individuals make financial decisions. This field of study goes beyond traditional economic theories, which assume that individuals are always rational and make decisions based on maximizing their own utility. Instead, behavioral economics acknowledges that human behavior is often influenced by cognitive biases, emotions, and social factors. By examining real-life financial decisions made by individuals, behavioral economics aims to uncover the underlying psychological mechanisms that drive these choices. For example, individuals may exhibit a tendency towards loss aversion, where they place greater importance on avoiding losses than on achieving gains. This can lead to suboptimal decision-making, such as holding onto losing investments for too long in the hope of recovering losses. Furthermore, behavioral economics highlights the impact of framing effects on decision-making. The way information is presented can significantly influence how individuals perceive risks and rewards, leading to different choices. For instance, individuals may be more willing to take risks to avoid losses when a situation is framed in terms of potential gains rather than losses. Moreover, behavioral economics considers the role of heuristics – mental shortcuts that individuals use to simplify decision-making processes. While heuristics can be useful in certain situations, they can also result in biases that lead to irrational financial decisions. For instance, individuals may exhibit overconfidence bias, believing that they have more knowledge and control over outcomes than they actually do.- Behavioral economics provides valuable insights into the complexities of human decision-making in the financial realm. By understanding the various cognitive biases, emotions, and social influences that shape individuals' choices, policymakers and financial professionals can design more effective strategies to promote better financial decision-making outcomes.
