[MUSIC] In this and the next video, we will talk about Neurofinance, another new trend in finance that tries to incorporate ideas taken from psychology and neuroscience into traditional finance. The purpose of this video is not so much to instantly improve your investment behavior, but the purpose is to show you the recent trends in finance. What are people doing to better understand the individual investor and financial markets, and is there a way to improve the finance industry based on these results? To understand what neurofinance does, let's first recap what finance does. For our purposes, finance deals with investments. Finance has given us means of analyzing financial products, like stocks, bonds, and derivatives. It is concerned with how such products should be priced, how they are traded, and how they interact in the market. As you have seen throughout this MOOC and possibly other MOOCs in this specialization, finance teaches us how we should put together a portfolio to achieve the optimal balance between expected returns and risks. So traditional finance tells us what we should be doing. But finance also observes investors in markets, and as it does, it notes that people don't seem to do what they should be doing. And remember that the market itself is a sum of many people reacting to information in the market. So, if individual investors don't do what they should be doing, then neither will the market. And this is where neurofinance comes in. You can think of it as a mixture of finance, psychology, and neuroscience. Neurofinance tries to make sense of the observation that many investors frequently behave irrationally. So, in the first step, neurofinance takes a close look at our actual investment behavior, then uses insights from psychology, such as knowledge about cognitive biases, to understand and possibly correct investor behavior. One such observation is that as opposed to what finance predicts, most investors trade rather frequently. As you have heard throughout the specialization, a good investment strategy is to carefully analyze the market and put together a portfolio that meets your needs in terms of expected returns and risk tolerance. You should then revisit your portfolio from time to time to see if you need to make changes, that is, if you need to rebalance it. If that's the case, you will buy and sell assets as you see fit, and then let the portfolio work for you. In other words, you should not be checking the value of your portfolio on a daily basis and constantly buy and sell, but that is exactly what people seem to be doing. Now this is a behavior that cannot easily be explained by traditional finance. In fact, when you look at the numbers, you realize that most people lose money because they are trading too often. So the strategy is clearly suboptimal. So this is one of these examples where insights from psychology can really help us understand what's going on. If you took the earlier MOOC on investment behavior, you may remember our discussion on cognitive bias in general, and in particular, on overconfidence. So, the following may not be entirely new to you. Overconfidence is a phenomenon by which people tend to overestimate their actual performance, or more importantly, are too sure about their beliefs. So, when talking about stocks, they may say, I am 90% sure that the stock will go up in the next year. But this may be a personal belief rather than something that is supported by the numbers. What you are saying is that this stock has very little risk attached to it. However, if you are too confident, that is, if you're overconfident, and the real probability of the stock rising is only about, say, 60%, then by buying the stock, you have taken on more risks than you thought you did. By including it in your portfolio, you have created a portfolio that is riskier than you thought it was. And if in addition to that, you say include a stock that you are sure will double in the next year, likely also due to overconfidence rather than the numbers, then you have created a portfolio that has more risk and less expected return than you thought it has. And then it's supported by the number, but it's just due to your overconfidence. Now phenomena like this provide insights into why people behave the way they do in financial markets. In fact cognitive biases are often better at explaining investor behavior than the numbers that those same investors have analyzed. So, by looking at psychology, we can make better predictions about individual investor behavior, and by extension, about market behavior. So far we have mostly focused on individual investors. But psychology and behavior finance also allow us to study market phenomena such as bubbles. By bringing people into the lab and have them trade in artificial financial markets, we can study how market bubbles are formed and how they burst. The lab setting allows us to control what information is available to the investor and study how they are using this information. Finally, the behavioral side of neuroscience allows us to disperse many of the assumptions that traditional finance makes. For instance, we typically assume that an investor carefully looks at all the information available to him. He then assesses the risk and expected returns and then takes rational decisions when putting together a portfolio. We also assume that we know our own risk tolerance or that someone who has been investing for a long time will do better in the market than a novice. But all of these can be shown to be false, and it is behavioral finance, and as we will see, neurofinance that helps us understand what is actually going on. So, in the next video, we will look at the brain during financial investments. [MUSIC]
