The Influence of Behavioral Finance Theories on Investment Decisions: A Comprehensive Literature Review

Abstract

Abstract: The objective of this article is to provide a comprehensive review of behavioral finance theories and their influence on investment decisions. Using a narrative review approach with a descriptive analysis method, this article synthesizes existing literature on key behavioral finance theories, including prospect theory, mental accounting, overconfidence bias, herding behavior, and anchoring. The research draws from peer-reviewed journal articles, books, and empirical studies to explore how these biases impact individual and institutional investors’ behavior, as well as market dynamics. The findings indicate that cognitive biases play a significant role in shaping investment decisions, often leading to suboptimal outcomes. For individual investors, biases such as overconfidence and loss aversion lead to excessive trading, poor risk management, and inefficient portfolio allocation. Institutional investors, despite their access to advanced data and models, are not immune to these biases, with herding behavior and overconfidence influencing their risk management strategies. Moreover, the review highlights how behavioral biases contribute to market anomalies, such as bubbles and crashes, which traditional finance models fail to explain adequately. The article concludes that integrating behavioral finance insights into both individual and institutional investment strategies can lead to better risk management and portfolio optimization. Additionally, financial literacy programs that incorporate behavioral finance principles offer practical tools for mitigating the negative effects of cognitive biases. As markets continue to evolve, especially with the rise of digital assets and automated investment platforms, understanding behavioral finance will be crucial for improving decision-making processes and market stability.