Financial markets and institutions always evolve in response to the desires, technologies, and regulatory constraints of the investors in the economy.
Knowing nothing more than these desires, technologies, and regulatory constraints we can predict the general shape of the investment environment.
All people (even smart ones) are affected by psychological biases. However, traditional finance has considered this irrelevant. Traditional finance assumes that people are rational and tells us how people should behave in order to maximize their wealth. These ideas have brought us arbitrage theory, portfolio theory, asset pricing theory, and option pricing theory.
Alternatively, behavioural finance studies how people actually behave in a financial setting. Specifically, it is the study of how psychology affects financial decisions, corporations, and the financial markets.
What is an Investment Environment?
This information is very timely because the current investment environment magnifies our psychological biases. Several powerful forces have affected investors recently. First, a strong and extended economy has created the disposable income for millions of new investors to enter the investment world. Most of these new investors have little or no formal education in finance. Second, this economy has spurred one of the longest and strongest bull markets in history. These new investors could have mistakenly attributed their high investment returns to their own capabilities instead of being a consequence of investing during a bull market. Finally, the rise of the Internet has led to increased investor participation in the investment process, allowing investors to trade, research, and chat online. These three factors have helped our psychological biases to flourish.