BEHAVIORAL FINANCE: HOW PSYCHOLOGY AFFECTS INVESTMENT DECISIONS

Abstract

Behavioral finance is a rapidly developing field at the intersection of finance and psychology, challenges the traditional notion of investor rationality. It explores how cognitive biases, emotions, and psychological heuristics systematically influence its financial decision-making processes. Contrary to classical financial theories—such as the Efficient Market Hypothesis (EMH)—which assume that investors act logically and markets are efficient that affects behavioral finance presents a more nuanced view of human behavior which emphasizing that investors are not always rational and that markets can reflect collective psychological distortions. This paper examines the key psychological factors that influence investment decisions, such as overconfidence, loss aversion, herd behavior, mental arithmetic, and anchoring, which are beneficial to financial systems. These biases can lead investors to deviate from optimal decision-making, often leading to suboptimal portfolio management, asset mispricing, and even market anomalies such as bubbles and crashes. The study examines how emotions such as fear and greed can amplify these uncertainties in finance or economics or accounting, especially during times of economic uncertainty or market volatility. This article, based on theoretical foundations and practical evidence, demonstrates the importance of behavioral finance (i.e., how human psychology influences financial decisions) in modern investment strategy and financial advisory services. The article also discusses the implications of this trend for public policymakers, institutional (large) investors, and ordinary shareholders. The author proposes a more comprehensive approach that takes into account the limitations of human psychology in improving financial literacy and regulating financial markets.