What is Behavioral Economics?

What is Behavioral Economics?


Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day is “Behavioral Economics”
A branch of economics that concentrates on explaining the economic decisions people make
in practice, especially when these conflict with what conventional economic theory predicts
they will do. Behaviorists try to augment or replace traditional ideas of economic rationality
with decision-making models borrowed from psychology. According to psychologists, people
are disproportionately influenced by a fear of feeling regret and will often forgo benefits
even to avoid only a small risk of feeling they have failed. They are also prone to cognitive
dissonance, often holding on to a belief plainly at odds with new evidence, usually because
the belief has been held and cherished for a long time. Then there is anchoring: people
are often overly influenced by outside suggestion. People apparently also suffer from status
quo bias: they are willing to take bigger gambles to maintain the status quo than they
would be to acquire it in the first place. Traditional utility theory assumes that people
make individual decisions in the context of the big picture. But psychologists have found
that they generally compartmentalize, often on superficial grounds. They then make choices
about things in one particular mental compartment without taking account of the implications
for things in other compartments. There is lots of evidence that people are
persistently and irrationally overconfident. They are also vulnerable to hindsight bias:
once something happens they overestimate the extent to which they could have predicted
it. Many of these traits are captured in prospect theory, which is at the heart of much of behavioral
economics.

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