The efficient market hypothesis proposes that at any given time in a liquid market, prices reflect all available information. There have been many studies, however, that document long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Many traditional models are based on the belief market participants always act in a rational and self-bettering, or wealth-maximizing, manner, severely limiting these models’ ability to make accurate or detailed predictions.

Behavioral finance attempts to fill this void by combining scientific insights into cognitive reasoning with conventional economic and financial theory. More specifically, behavioral finance studies different psychological biases that humans possess. These biases, or mental shortcuts, while having their place and purpose in nature, lead to irrational investment decisions. This understanding, at a collective level, gives a clearer explanation of why bubbles and panics occur. Also, investors and portfolio managers have a vested interest in understanding behavioral finance, not only to capitalize on stock and bond market fluctuations but also to be more aware of their own decision-making process.

A prominent psychological bias is the herd instinct, which leads people to follow popular trends without any deep thought of their own. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. Herd instinct is correlated closely with empathy gap, which is an inability to make rational decisions under emotional strains such as anxiety, anger or excitement.

The self-attribution bias, a habit of attributing favorable outcomes to expertise and unfavorable outcomes to bad luck or an exogenous event, is also closely studied within behavioral finance. George Soros, a highly successful investor, is known to account for this tendency by keeping a journal log of his reasoning behind every investment decision.

Many other tendencies are studied within behavioral finance, including loss aversion, or disliking losses more than liking gains; confirmation bias, or acknowledging confirmatory evidence while ignoring contradictory evidence; availability bias, or judging outcomes by previous experiences of similar outcomes; disposition effect, or selling investments after little gains but hanging on to them even after significant losses; and familiarity bias, or preferring familiar rather than new investment opportunities.

This is the tendency of people to designate money for a certain purpose. For instance, they divide up money and treat it differently, depending what “account” it’s in. So, money in a savings jar is treated differently than money meant for debt repayment. People tend to say that money in that savings jar can’t be used for another purpose, even if it means paying down debt at 15% interest.

Following the crowd is something quite common, and it results in some of the most interesting effects. As the larger group does something — like buy a “hot” stock, or sell in a panic when the market drops — individuals tend to follow suit. Breaking herd mentality is one of the best things you can do for your own finances.

This is the idea that you attach your spending level to a specific reference. You might think that a “good” bottle of wine should cost a certain amount of money. You might see the most expensive wine on a restaurant’s list costs $100 a bottle. Normally, you would only spend $25 on a bottle of wine. But since you are now anchored to the idea of “the best” costing $100, you don’t want to spend “only” $25. Instead, you “compromise” on a $45 bottle of wine. You spent more than you wanted, because of that anchor. The same thing happens with clothes, shoes, homes, and a number of other purchases.

Most people rate their intelligence as “above average.” At least that’s what my Psychology Ph.D. husband tells me. He also points out that most people see success as something that they caused. Setbacks, though, are blamed on external forces. So, an investor might believe that he or she is a stock picking genius when an investment performs well. However, when that investment tanks, that same person, rather than believing that he or she is below average at stock picking, blames the drop on “the market” or “the economy.”