Classical economic theory assumes investors act rationally, yet real‑world markets reveal a tapestry of cognitive biases and emotional influences. Prospect theory, introduced by Kahneman and Tversky, illustrates how individuals weigh losses more heavily than equivalent gains, leading to risk‑averse choices in profit situations and risk‑seeking behavior in losses. Herd mentality drives asset bubbles, as investors buy rising assets out of fear of missing out, only to reverse course in panics.
Anchoring bias causes traders to cling to arbitrary reference points such as purchase prices when making decisions, while overconfidence can fuel excessive trading and underestimation of risk. Behavioral finance explores these psychological pitfalls and proposes corrective measures: pre‑commitment strategies, algorithmic execution plans and systematic rebalancing help remove emotion from investing. By acknowledging human imperfection, financial professionals can design products and processes that foster better outcomes for clients.