Behavioural Finance

Behavioural Finance is the psychological influence that affects an investor’s financial behaviour. The primary purpose of behavioural finance is to understand why investors make certain financial choices and how these choices affect the market. Since this depends on several individuals, it cannot be predicted as heterogeneous. Investors are psychologically influential so behavioural finance is an important element in the stock market. Investors can also be psychologically biased towards certain financial instruments in the market. These biases occur due to a variety of judgments.

This study helps to understand how investors deviate from certain financial decisions and helps other investors to make better and more rational financial decisions. These financial decisions can be investments, payments, personal debt, or others. All these decisions can be influenced by human emotions, biases, and certain limitations of the mind. This study uses psychology to explain why investors make bad decisions at times.

Behavioural finance is a relevant study that helps a lot of investors. When a decision has to be made from a vast choice, sometimes a person tends to get confused about the decision making. This is where behavioural finance plays its role by examining human decision-making behaviour and nudge them into choosing the optimal choice from the vast choices granted. They focus on the fact that investors are not always rational, they too have limits and can be influenced by several biases. These decisions from the investors can always affect the market.

How was behavioural finance developed?

Richard Thaler developed the behavioural finance theory. He was a finance theorist. Thaler was also accompanied by Amos Tversky and Daniel Kahneman. They are considered the founding fathers of behavioural finance. They were psychologists who initially developed behavioural economics and later this gave rise to behavioural finance.

(Source: Wealth Management)

Whereas the mainstream financial theory states that markets and individuals are irrational, free of emotions, have self-control, and are profit maximizers. They prove that the investors can process information unbiased. They also believe that investors will not be confused by cognitive errors or information processing errors. Behavioural finance is just contrary to the mainstream financial theory, they believe that the investors can be irrational, and their emotions also play an influential role in the kind of investment undertaken.

Behavioural finance errors/issues:

1. Self-deception

Sometimes individuals mistakenly think that they know more than they do. This can lead to miss information and leaving out certain important details. Here the individual tends to rationalize or deny the relevant information. This situation arises when an individual has selective attention, biased information search, or forgetting things.

2. Heuristic simplification

They are cognitive shortcuts that simplify decisions. These include information processing errors and encompasses emotional factors. They can also lead to cognitive biases.

3. Emotion

This refers to an individual's decision-making capacity according to their emotional state. This can take their decision-making off track from rational thinking. When an individual goes through a complex situation, rather than thinking more about the issue they tend to follow their instincts while taking decisions. There is always a subconscious desire to avoid losses but due to the situation’s complications and emotional struggle, the decision taken may not be the optimal and best choice among others.

4. Social influence

This is about how an individual’s decision-making is influenced by others. Social influences can reconstruct an individual’s way of thinking and impact their actions and behaviours. Social interactions with other individuals and investors can influence an investor and motivates them to behave rationally. Not just other individuals but the internet can also alter an investor's financial decisions.

(Source: Leverage Edu)

5. Conformational Bias

This is a tendency where the individuals pay close attention to the information that confirms their beliefs and tends to ignore the rest of the information. This is a common type of error seen in a lot of people. Everyone tends to look for confirming information rather than disconfirming information. To overcome this type of error, an individual has to look for pieces of information that disapprove of their ideas and beliefs.

6. Familiarity Bias

This happens when the investors tend to invest in what they know and what they are familiar with. These might be by investing in locally owned companies or domestic companies. This may restrain the investor’s financial choice, their investments will not be diversified into different sectors and other types of investments.

Is behavioural finance helpful?

Behavioural finance helps to analyze market returns and helps the investors to beat the market. Their studies are more academic than practical management. They do not help the investors to develop any strategy that they can use to outperform the market, but they help the investors to know more about the mistakes that they have made while investing in a financial instrument.

They concentrate more on an individual’s behaviour while deciding market investments and other financial choices. An individual has to manage their emotions and pay more attention to the market to overcome behavioural finance biases. The financial market is considered a bubble that can expand and at the same time explode at any moment. So the practical side of behavioural finance may not be that beneficial. Since this study concentrates more on the behavioural patterns of the individuals. These behavioural patterns can be advantageous to investors who are new to the market or are planning to diversify their investment choices.

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Author - Aleesha A Vithayathil

Content Writer at Escribo.