This chapter examines the relevance of psychology to the world of investing. Psychologists are concerned with understanding all workings of the brain—the part that controls cognition (the process of thinking and knowing), as well as the part that controls emotion. This leads them to investigate how we learn, how we think, how we communicate, how we experience emotions, how we process information and make decisions, and how we form the core beliefs that guide our behavior. Behavioral finance, which seeks to explain market inefficiencies using psychological theories, was born of the academic work of Daniel Kahneman and Amos Tversky, especially their prospect theory. This chapter considers the concept of loss aversion, embedded in prospect theory, and how it forced economists to rethink their basic assumptions of how people make decisions. It also discusses the ideas of scholars such as Benjamin Graham, Terence Odean, Fischer Black, Claude E. Shannon, and Charlie Munger, along with the importance of mental models for investors.
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