What is Behavioural Finance?

What is Behavioural Finance?

One of emerging areas in global economics and finance is behavioural finance, which investigates the emotional and cognitive factors that impact the financial decision-making process of individual investors, families and even large organisations. A combination of the field of psychology and money management with conventional economic theories, the aim of behavioural finance is to establish how certain people or groups make investment decisions. What factors influence their decision making and how does it all impact the financial markets on the whole?

Why Behavioural Finance?

The Efficient Market Hypothesis (EMH) is based on the assumption that in any liquid market, prices reflect all the important information at any given time. But, studies over a long period of time have found that apart from prices, investor mentality also plays a part in how markets move. The basic assumption that investors always act rationally is flawed, and this limits various finance models from providing accurate predictions.

Behavioural finance brings the psychological biases of humans into the equation. These biases are responsible for many irrational financial decisions an individual can make. We are able to gain insight into why markets collapse and bubbles burst. What makes people panic sell at lower prices or what makes them buy instruments at a high price? Another way in which this field serves is by helping financial companies create better products to suit their customer needs and aspirations.

Marketers can create strategies, capitalising on investor psychology, which, in turn, could be influenced by optimism or conservatism. Portfolio managers can be more aware of their own decision-making process when faced with market fluctuations. So, behavioural finance has brought in modifications to the foundation theories of standard finance, such as:

  • Investors are not “rational,: they are “normal.” What separates rational investors from normal ones? According to Miller and Modigliani, it is the reluctance to accept losses.
  • Markets are not efficient. Investors cannot simply create portfolios based on the mean-variance portfolio theory. Returns are determined more by risk.

Let’s take a look at some popular theories on this broad subject.

Herd Instinct of Investors

A popular psychological bias among investors is the “herd instinct.” People follow trends blindly without any logic of their own. It is a common phenomenon in the stock and forex markets, which accounts for panic sell-offs and rallies. This gives rise to the theory of “empathy gap,” which says that under tough constraints, individuals generally do not make wise decisions.

Herd mentality encompasses many other psychological biases. For example, “attention bias,” which suggests that people tend to invest in shares of big and well-known companies, even if other shares can offer better returns.

Confirmation Bias

This theory suggests that investors only pay heed to information that supports their existing opinions or biases, rather than any information that refutes it. This one-sided approach towards evaluating market dynamics can prove to be disastrous. The theory is another explanation as to why bullish investors tend to remain bullish or bears continue to be bearish, despite the market indicators suggesting a different path to be taken.

Behavioural Portfolio Theory

Introduced by Shefrin and Statman in 2000, this theory is based on the premise that investors have many mental goals when it comes to investment. It is sort of a portfolio pyramid, where every goal is placed according to their importance in a person’s life; it could be marriage, children’s education, retirement, buying a home or even planning vacations. The attitude towards risk varies according to the different layers on this pyramid, which determine wealth allocation towards each of these goals.

So, a person might invest more in children’s education rather than a vacation cruise. It could be true the other way around too. Factors like age, sex, economic and social background come into play here.

How is Behavioural Finance Used to the Investor’s Advantage?

It is a surprising but true fact that more often our investment decisions are not governed by careful deliberation of risks and returns, but by our subconscious, which is responsible for our emotional reactions. When these emotions are misguided, we make mistakes. There are three main factors to consider here:

  1. Role of subconscious thinking
  2. Emotional reactions
  3. Value of practicing strategies.

Logical thinking and emotions are two forces at play in our subconscious. While the former is all about stats and figures, the latter is about comfort. The phenomenon of motivated reasoning is the interplay between these two factors. As investors gain more experience, they tend to identify the decisions that led to losses as bad and those that led to gains as good. This is called the “self-attribution” bias, a habit of attributing unfavourable outcomes to external events, rather than one’s own faulty decisions. This rationale undermines the importance of risk management.

Most people also consider their decision making abilities superior to that of others. They don’t express regret over bad decisions and move away from rationality. Recognising such tendencies is important to avoid losses.

So, by practicing self-aware investing, investors can refine their decisions over time. The most successful traders have benefitted from trading journals, where they record their thoughts and emotions while making investment decisions on a daily basis. Through this, they identify behavioural and reasoning patterns in a given market condition, over time. This helps traders identify what factors influence their decision making and in what manner. They recognise the instances when their own faulty thinking has impacted the financial returns.

Contrary to common belief, investing is not guesswork or gambling, it is based on economic theories and investor psychology. Through behavioural finance, it is possible to define good investing behaviour and pave the way for stable markets. It can also be a good foundation to trading success.

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