Definition: Behavioral finance is that discipline of behavioral economics which analyzes the impact of human psychology on the investors’ actions. Thus, ultimately shaping the investing decisions of individuals, directors, managers, analysts, advisors, researchers, speculators and other market players.
Behavioral finance contradicts the theory of traditional finance. This phenomenon considers human beings as normal and irrational at times. Hence, it brings forward the consequences of personal biases over investment decisions.
Human beings are emotional and tend to make cognitive mistakes resulting in false decision-making.
Content: Behavioral Finance
Foundation of Behavioral Finance
The theory of behavioral finance is based on the following three criteria:
- Psychology: In behavioral finance, we study the impact of a person’s attitude, emotions and mindset over his/her investing decisions.
- Sociology: It emphasizes the effect of social relations and the conduct of an individual while being in a group or a society over his/her decision-making ability.
- Finance: The sum available with the investor, price and future value of the security also influences the capital allocation functions.
Behavioral Finance Concepts
When we look forward to smart investment decision-making, we should be aware of the various perceptions of behavioral finance.
These are thoroughly explained below:
People tend to follow the investing pattern of the other investors or say the crowd to bring about the major economic fluctuations.
For instance; when a piece of negative news about a stock is reported, the investors start selling off their holdings altogether resulting in price contraction.
The human nature of pre-allocating the available funds for a definite purpose due to their intuitive approach, adversely affect their investing decisions.
For instance; keeping the excess money in savings account rather than in fixed deposit, to ensure easy withdrawal whenever required.
Many a time investors’ decision-making processes rely upon their psychological benchmark misleading through irrelevant information. In this process, sometimes the actual value or the future profit which the security may yield is overlooked.
For instance; people deciding to spend up to a certain level or signifying the purchase price of the stock.
High Self Rating
The overconfident investors trust in their knowledge way more than anything else. Their decisions are based on this self -attrition.
For instance; a mutual fund investor self-designs his investment portfolio.
Most of the times, investors fail to become rational while decision making. The emotions of fear, anxiety, panic, anger, jealousy and excitement take over the process of investment decision making.
For instance; many people got excited seeing the performance of bitcoins and blindly invested in it, finally losing their money.
Scope of Behavioral Finance
Behavioral finance has proved to be highly relevant for the individuals, managers, financial advisors, market speculators, teachers, analysts and many others.
Let us discuss its significance to the following:
- Investors: Behavioral finance is a means to analyze the common mistakes which the investors make while selecting particular security. It enlightens upon on the common biases which restrict people to make rational investment decisions.
- Corporations: In the context of companies, the behavioral finance studies the impact of the mindset of financial advisors, directors and managers that influence corporate investment decisions.
- Markets: When it comes to stock price analysis and speculation, behavioral finance trends are widely applicable. Since the experts believe that the stock market is not completely efficient, the efficient market hypothesis (EMH) cannot work independently.
- Regulators: The financial regulators consider behavioral finance as a means to refrain market failure and future crisis by transforming the market players’ attitude towards certain security.
- Educators: For the educators and teachers behavioral finance helps to depart knowledge on rational decision making and elaborating the psychological barriers which hinder the process.
Behavioral Finance Biases
Human behaviour usually impedes the decision-making of oneself. Let us discuss some of the major prejudices in this context:
Experiential Bias: Sometimes the investor frames their decision around a prior event and assumes that the same thing will repeat in future also.
Therefore, the person follows his/her belief to invest or not to invest in a certain stock, ending up being experientially biased towards it.
Overconfidence Bias: When the investor believes in himself way too much, he/she would probably end up making a false investment decision.
Thus, an overconfident investor ignores all the facts and figures and strongly relies on self assumptions and believes while going with a particular investment option.
Disposition Bias: While being disposition biased, the investor sells the high earning investments of the portfolio, to make instant profits; and holds on the poor performing stocks.
The idea behind keeping the losers is to wait for a favourable time for selling these stocks to at least recover the amount invested in it. However, the investor misconceives the stock performance by its entry price.
Familiarity Bias: The investors who are familiarity biased, tend to put in their funds in the companies which are easily recognizable by them.
Such investors hesitate to invest in the companies which they have hardly heard of, even if they show high potential for growth. Therefore, they have limited stocks in their investment portfolio restricting its diversification.
Hindsight Bias: Many investors seldom learn from their experiences and live upon the delusion of knowing everything.
This is where they often make mistake in analyzing certain investment opportunity for their results and the forces driving towards such an outcome.
Framing Bias: When people trust the information provided to them and hardly bothers to investigate the facts and figures by themselves before making the investment, is considered as framing bias.
Whatever data about the security is framed in front of the investors, they find to be real and depends upon it for their taking investment decision.
Confirmation Bias: The investor sometimes overlooks the negative news or information while being overwhelmed with the positive side of the stock. Thus, ignoring the fact that this glittering good news about the stocks may not possibly turn to be gold.
In short, confirmation bias takes place when making an investment decision, the investor behaves irrationally by emphasizing on only the positive or the negative side of the stock.
Narrative Fallacy: A security wrapped up with a nice story is easily sellable to those who fantasize more on stories rather than the facts.
Hence, such investors often make mistake landing upon the stocks which look promising but fails to perform as expected.
Loss Aversion: When the investor has previously gone through the trauma of losing a huge amount, his/her investing decision is overshadowed by this past experience.
Thus, the investor focuses more on minimizing loss and holds the stock irrelevantly for a long period, as a result of loss aversion.
Before knowing what is right, we should be very clear about what is going wrong. Isn’t it?
Therefore, understanding the whole phenomena of how a person is trapped in a false investment bubble when his/her mentality overshadows the facts, becomes essential. This is exactly what behavioral finance highlights.