Investors aren’t always rational; they are prone to making irrational decisions. At some point or other, they let their personal bias make imperfect decisions.
Behavioural finance is the field that dives deep into the psychology of the decisions made by investors. It studies the different biases which impact the decision-making capacity of financial analysts. Behavioural Finance theory is in stark contrast with the Traditional finance theory which works on the assumption that people as investors are rational with no cognitive errors and that the stock and bond markets are efficient.
Among many ways to categorize the decision-making biases of investors, some of them are:
● Anchoring Bias: Anchoring is our tendency to estimate worth or value based on our pre-existing information. So investors making decisions based on their initial knowledge that has no logical relevance to the investment will lead to an ill-informed decision.
● Emotional Bias: No human being is sans emotions and emotions are bound to alter the decision-making capacity of investors. Some of the emotional bias are:
● Overconfidence Bias
● Hindsight Bias
● Self-Attribution Bias
● Confirmation Bias
● Herd Behavior: It is the tendency to follow the herd and copy what others are doing.
● Heuristic Simplification: It is the simplification or shortcuts to critical thinking. It allows people to solve problems quickly. Although it is found to be beneficial in some cases it leads to a wrong decision in many cases.
Ways to deal with Biases
● Asking oneself a set of multiple questions before making a decision helps significantly in escaping the pitfalls of behavioural bias.
● Preconceived notions should be effectively scrutinized and new information should be systematically processed.
● One must focus on the process rather than the outcome.
● Establishing a logical decision-making process helps in escaping errors.
Need for Behavioral Finance
Behavioural Finance provides a human perspective to the activity of investing. It combines the sciences of economics, finance and psychology and answers questions that are not pointed out by traditional finance theory and classical economics. It explains human limitations and complications which are an inherent part of the financial world.
Citations
● “Behavioral Finance: How Processing errors and biases impact investors' '. Corporatefinanceinstitute.com. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-finance/
● Rambow,John. “Behavioral finance is a science that analyzes why investors often make misguided choices”. Businessinsider.in,4 February 2021. https://www.businessinsider.in/personal-finance/news/behavioral-finance-is-a-science-that-analyzes-why-investors-often-make-misguided-choices/articleshow/80691211.cms
● Cormier, Warren.“What is Behavioral Finance- and why do we need it?” asppa.org.4 September 2015. https://www.asppa.org/news-resources/browse-topics/what-behavioral-finance-%E2%80%94-and-why-do-we-need-it
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