Understanding Emotional Finance in Behavioral Finance

Understanding Emotional Finance in Behavioral Finance

Emotional finance is a subfield of behavioral finance that focuses on how unconscious feelings and emotions impact individual investment decisions and market activity. This concept recognizes that people's decisions are not solely based on rational calculations but are also influenced by psychological factors, including emotions like fear and greed, as well as cognitive biases.

Emotions and Investment Decisions

Emotional finance theory distinguishes the traditional understanding of risk, which is perceived as known and measurable, from the concept of uncertainty - the inability to predict future returns. Conventional models of risk serve as a psychological defense against uncertainty and the "real" risk of anxiety and helplessness that stems from this.

Emotional Finance in Practice

Emotional finance can be applied in various areas to improve our understanding of investment behavior. It highlights the impact of emotions on investment decisions, such as the need for trust and reassurance in investment relationships and the role of stories in promoting this trust.

Impact on Market Behaviors

Emotional finance also predicts an unconscious need for stock prices to have already risen for investors to have the confidence and trust to invest in them, which could lead to individual stocks being mispriced. Speculation and unconscious excitement help drive investment behavior, with the stock market generating many of the same emotions experienced by gambling.

Emotional Finance and Market Bubbles

Emotional finance can explain asset pricing bubbles and financial crises, such as the dot-com bubble in the late 1990s and the 2008 Global Financial Crisis. Traditional and behavioral finance theories have difficulty accounting for these events fully because they ignore the unconscious processes at work.

Future of Emotional Finance

While the underlying theory of emotional finance is already reasonably developed, the next stage is to explore the empirical application of emotional finance in more detail, using both quantitative and qualitative methodologies. This field has the potential to significantly increase our knowledge and understanding of financial activity and market behaviors.

In conclusion, emotional finance is an essential component of behavioral finance, as it highlights the impact of emotions and unconscious processes on individual investment decisions and market activity. Understanding these emotional biases can help investors make more informed decisions and potentially avoid costly mistakes.