Keywords & Meanings – Behavioral Finance Glossary
A comprehensive A-Z list of key terms used in Behavioral Finance.
A
Active Management
An investment strategy where the manager attempts to outperform the market benchmark through stock selection and market timing.
Affect Heuristic
Making decisions based on current emotions (fear, joy) rather than objective analysis. "If I feel good about it, it's a good investment."
Allais Paradox
A choice problem designed by Maurice Allais (1953) to show an inconsistency of actual observed choices with the predictions of expected utility theory.
Anchoring
A cognitive bias where an individual relies too heavily on an initial piece of information (the "anchor") when making decisions. Example: 52-week high price.
Arbitrage
The simultaneous purchase and sale of an asset to profit from a difference in the price. In behavioral finance, arbitrage is often limited and risky.
Availability Heuristic
A mental shortcut that relies on immediate examples that come to a given person's mind when evaluating a specific topic, concept, method or decision.
B
Base Rate Neglect
The tendency to ignore the general prevalence (base rate) of a characteristic in a population when judging the probability of a specific case.
Behavioral Finance
A field of finance that proposes psychology-based theories to explain stock market anomalies, such as severe rises or falls in stock price.
Bounded Rationality
The idea that in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.
C
Calibration
The degree to which confidence matches accuracy. Overconfidence is a form of poor calibration.
Cognitive Dissonance
The mental discomfort experienced by a person who holds two or more contradictory beliefs, ideas, or values.
Confirmation Bias
The tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values.
Conservatism Bias
The tendency to revise one's belief insufficiently when presented with new evidence.
D
Disposition Effect
The tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value.
Dividend Smoothing
The practice of maintaining a relatively consistent dividend payout despite volatility in earnings.
E
Efficient Market Hypothesis (EMH)
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.
Endowment Effect
The hypothesis that people ascribe more value to things merely because they own them.
Expected Utility Theory (EUT)
A theory used as a model of rational decision-making where individuals choose between risky prospects by comparing their expected utility values.
F
Framing Effect
The cognitive bias wherein an individual's choice from a set of options is influenced more by how the information is presented than by the information itself.
Fundamental Attribution Error
The tendency to overemphasize personal characteristics and ignore situational factors in judging others' behavior. "He lost money because he's stupid; I lost due to bad luck."
G
Gambler's Fallacy
The mistaken belief that, if something happens more frequently than normal during a given period, it will happen less frequently in the future (reversal to mean).
H
Herding
The tendency for individuals to mimic the actions (rational or irrational) of a larger group.
Hindsight Bias
The tendency of people to overestimate their ability to have predicted an outcome that could not possibly have been predicted. "I knew it all along!"
Home Bias
The tendency for investors to invest in a large amount of domestic equities, despite the purported benefits of diversifying into foreign equities.
Homo Economicus
The theoretical "economic human" who is rational, self-interested, and maximizes utility.
House Money Effect
The tendency for investors to take more risk with money they have won or gained effortlessly (viewing it as "house money") than with their own hard-earned capital.
I
Illusion of Control
The tendency for people to overestimate their ability to control events; for example, feeling that you control the outcome of a coin toss if you throw it yourself.
L
Law of Small Numbers
The incorrect belief that small samples truly represent the populations from which they are drawn.
Loss Aversion
The tendency to prefer avoiding losses to acquiring equivalent gains. It is a cornerstone of Prospect Theory.
M
Mental Accounting
The set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Treating money differently based on its source or intended use.
Momentum
The tendency for assets that have performed well in the past to continue to perform well in the future.
Myopic Loss Aversion
The combination of loss aversion and a tendency to evaluate outcomes frequently. It leads investors to be too conservative because they see short-term losses often.
N
Noise Trader
A trader whose decisions are based on pseudo-signals (noise) rather than specific fundamental information.
Nudge
A concept in behavioral science that proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals.
O
Overconfidence
A bias in which a person's subjective confidence in his or her judgments is reliably greater than the objective accuracy of those judgments.
Overreaction
The tendency of participants to overreact to new information, causing prices to move too far in one direction.
P
Planning Fallacy
A phenomenon in which predictions about how much time will be needed to complete a future task display an optimism bias and underestimate the time needed.
Prospect Theory
A behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known.
R
Recency Bias
The tendency to think that trends and patterns we observe in the recent past remain for the future.
Regret Aversion
The tendency to fear that one's decision will turn out to be wrong in hindsight.
Representativeness Heuristic
A mental shortcut used when making judgments about the probability of an event under uncertainty.
S
Satisficing
A decision-making strategy or cognitive heuristic that entails searching through the available alternatives until an acceptability threshold is met.
Self-Attribution Bias
The tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while blaming failures on outside influences, such as bad luck.
Status Quo Bias
An emotional bias; a preference for the current state of affairs. The current baseline (or status quo) is taken as a reference point, and any change from that baseline is perceived as a loss.
Sunk Cost Fallacy
The phenomenon where a person is reluctant to abandon a strategy or course of action because they have invested heavily in it, even when it is clear that abandonment would be more beneficial.
T
Thaler, Richard
A Nobel Prize-winning economist (2017) known for his work in behavioral finance, including Mental Accounting and Nudging.
U
Utility
A measure of preferences over some set of goods and services; often represents satisfaction or happiness.
V
Value Function
In Prospect Theory, a function that assigns a value to an outcome. It is S-shaped: concave for gains, convex for losses, and steeper for losses.
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