Traditionally the study of economics and finance is based on the assumption that people always behave rationally. In reality people often behave irrationally, ie not in their own quantifiably best interests. Behavioral finance, the combination of psychology and financial theory, is now a growing academic discipline. This article reviews some of its key features and suggests why they should be important to every investor.

It's important to understand behavioral finance for 2 reasons. First, knowledge of investor psychology can help prevent you making the most common psychological mistakes. Second, it can make you aware of the mistakes of others, particularly the masses, placing you in a position to profit from the madness of crowds.

Efficient market theory suggests the price of any investment instrument at any time is its correct price according to all publicly known information. In the information age of globally networked computers it's true that anything known about a stock etc will be factored into its price virtually instantaneously. Yet the human/emotional element remains a significant determinant of price. More accurately we might say:

Current Price = True Price +/- psychological factor

where the 'psychological factor' varies wildly.

People tend to be overconfident in their own abilities. The classic illustration is when we're asked about our driving skills. Most people consider themselves above average, though by definition, 50% of us must be worse than average. Investment-wise we may believe we're capable of making the choices that will beat the market. In reality most full-time professional fund managers fail to achieve that. To reliably beat the market requires we have knowledge of the future. Short of being infallibly psychic that is impossible. Overconfidence can lead us to waste a small fortune on fees and commissions chasing mediocrity.

Humans have an inherent desire to seek pride and avoid regret. This can lead to irrational investment decisions with winners being sold too soon, and - particularly - losers being held too long. Prices tend to trend (remember the Wall Street mantra "the trend is your friend"), so best to hold winners until the momentum subsides and to quit losers before you lose too much. Bear in mind also whether you're in a well-chosen investment for the long run, or looking for a quick buck.

Mental accounting is our tendency to segregate funds for specific purposes. In one sense mental accounting can help us maintain a tight budget. But it can also lead to irrationality, eg we maintain costly credit card debt while directing funds to pay off lower interest debt or saving at relatively low interest rates. It's good to allocate assets to specific purposes (accounts), but be flexible enough to shift between them when there are clear advantages for doing so.

The comfort of familiarity may lead to irrational investing behavior. Most stock investments are held in the investor's own country, yet the world is increasingly becoming a global economy. Developing nations tend to show significantly higher economic growth than G7 members, shouldn't we want a piece of this? Conversely, investing in other developed countries provides safety in the form of diversification - each nation's economy performs slightly different than others so investing in a number spreads the risk.

Perhaps the most dangerous risk of familiarity is holding too large a stake in your own industry or employer. Employers sensibly give stock or offer it cheaply to employees in the hope that by making them co-owners workers will be incentivized to go the extra mile. But for the employee it may not be so good a deal. If you're heavily invested in your employer (or industry) any downturn will not only put your assets at risk but also your job as well. If your employer gives you stock or offers it cheap it probably makes sense to take advantage. But as soon as any penalty periods are up, consider selling up and diversifying elsewhere.

Human beings are social creatures. We seek the companionship and approval of our peers and feel safe when we're doing the same as others. The entire fashion industry is built on this principle. And so it goes in investing. Once the herd flock to a good thing the result is a bubble, from Dutch tulips to dotcoms. The key is to recognize a bubble when you see it; the clues are in the violation of tried and trusted valuation principles. Sure, there's money to be made in bubbles due to the 'greater fool' principle. However much you pay for a piece of junk there's always a greater fool willing to pay more. The sensible approach to bubbles is to avoid them like the plague. The gambler might jump on the bandwagon and get out before the inevitable crash, but if you try this be sure to treat it as a gamble rather than an investment and only with money you can afford to lose.