While it has always been known that investors do not approach investment decision making with perfect cognisance and in a well informed and perfectly rational manner, it had been assumed that investors, on the whole, acted as if they did. Without a clear sense of knowing how and why investors deviated from this model, it was difficult to articulate anything rigorous or distinctive about the way in which investment decision making and markets really worked. In recent years, however, this has changed as significant advances have been made in what has become known as Behavioural Finance.
Rather than making simplified assumptions about the way investors approach investment decision making, behavioural finance instead analyses the way in which cognitive biases and the social aspect of human behaviour systematically enter the decision making process. Although yet to enter the mainstream, behavioural finance, by fusing finance theory with these biases and the impact of the actions and opinions of others on investment decision making, attempts to explain why pricing anomalies, profitable trading strategies, bubbles and crashes and those other phenomena that are at odds with the Efficient Markets Hypothesis (EMH), the backbone of finance theory since the 1960s, continue to be observed.
However, despite behavioural finance being a useful tool for observing how financial markets work rather than theorising about how they should work, the challenge remains to consolidate what has become an extensive body of research into a set of simple unifying principles.