Behavioral finance is the study of economic affairs and psychology. Behavioral finance shows how an investor makes emotional financial decisions contrary to conventional business decisions. Unlike traditional finance, behavioral finance shows how emotional biases and human feelings are incorporated into decision-making.
An important feature of behavioral finance is the impact of psychological bias on investment decisions. Understanding behavioral finance bias is crucial for implementing business decisions in an organisation. Read on to gain a deeper insight into financial bias.
What is behavioral finance?
Behavioral finance is an amalgamation of psychology and economic matters. It is important to evaluate the impact of emotional bias on financial decision-making. While traditional finance assumes rationality of business decisions, behavioral finance acknowledges the irrationality of decisions based on biases. Primarily, behavioral finance biases revolve around five key concepts:
- Mental accounting refers to the tendency of individuals to allocate resources for particular purposes.
- Emotional gap refers to the inclination to make decisions based on strained emotions.
- Herd behaviour refers to how an individual tends to mimic the financial behaviour of most individuals. Herd behaviour is quite prevalent in the stock market.
- Self-attribution refers to the inclination of an individual to make decisions with excessive reliance on one’s expertise. The bias of overconfidence lies at the root of self-attributive behavioral finance.
- Anchoring refers to the association of a spending level with a particular reference.
To understand the concepts of behavioral finance it is recommended to enroll in financial services courses by Imarticus.
An exploration of the psychological factors that affect business decisions
Cognitive factors have a significant impact on investment outcomes. A few key psychological factors that influence business decisions are described below:
Overconfidence bias
Investors often tend to overestimate their predictive power and knowledge while making business decisions. Overconfidence bias compels investors to execute frequent trades leading to the incurrence of risks. For example, an investor may ignore a market downturn and continue trading despite the risks leading to poor portfolio performance.
Loss aversion
Investors often prefer avoiding losses to attaining equivalent profits. The loss aversion theory suggests that the pain of incurring a loss is more impactful than the pleasure of acquiring gains. For example, an investor may decline to sell a deteriorating stock hoping that the price of the stock may rebound.
Confirmation bias
Investors tend to extract information that confirms the existing beliefs of the investor despite contradictory evidence. Such investors tend to focus on positive news updates about a particular stock while ignoring the associated risks. Ignoring the signs of deteriorating market trends often results in poor investment decisions and losses.
Regret aversion
Regret aversion refers to an irrational fear of making regrettable investment choices leading to avoidance of making decisions. Regret aversion bias goes beyond fiscal loss to emotional discomfort. Investors tend to avoid the sale of collapsing assets fearing that they may regret the business decision. This leads to wasted prospects of portfolio diversification.
Bias of fear and greed
Fear and greed often influence value investing and behavioral finance decision-making in an organisation. Emotional investing causes poor decision-making in stock trading. Fear and greed trigger volatile market trends and stock crashes.
Mental accounting
Mental accounting is a behavioral pattern of treating assets differently based on the source of the assets. Instead of assessing the overall financial state, investors make random business decisions based on the source of the stock. Mental accounting often leads to irrational decision-making in business. For example, an investor tends to be traditionalist about retirement savings while spending money thoughtlessly from a different account.
Recency bias
Recency bias makes an investor prioritise recent market patterns over historical data. Stockholders generally tend to give more importance to short-term market development and make flawed decisions. For example, an investor may chase current market trends and incur losses due to neglect of historical market patterns.
Anchoring bias
Shareholders often feel inclined to rely on a particular piece of market information while ignoring other factors. This piece of market information is considered an anchor. Investors often skip rudimentary market analysis and choose to stick to their anchor bias for making business decisions. For example, a stockholder may hold onto an asset until the asset process reaches a past peak price while simultaneously ignoring current market patterns.
Herd bias
Herd bias is one of the most prominent biases that investors harbour. Shareholders tend to imitate the behaviour of a larger group of investors while neglecting appropriate analysis of the market. Herd behaviour creates a bandwagon effect in which stockholders tend to follow generic trading patterns instead of conducting independent evaluations. Such a bias often results in market crashes and asset bubble formation. For example, purchasing a booming asset without assessing the company incurs huge losses when the asset bubble bursts.
Availability bias
Availability bias refers to a behavioral tendency to give undue importance to news and personal experiences. Such a bias can compel investors to waste profitable opportunities depending on what is readily available in their minds. Such investors tend to invest in assets based on success stories while neglecting an evaluation of the assets.
Conclusion
Psychological factors like herd mentality, overconfidence, and emotional biases have a great impact on business decisions. Behavioral finance recognises the infusion of emotions and business decisions. Awareness of psychological influences helps in avoiding investment errors and making rational decisions.
Budding investors may consider enrolling in the Advanced Management Programme in Financial Services and Capital Markets at Imarticus to understand behavioral finance. Understanding behavioral finance is crucial for accurate financial planning. You may read more on this at the official website of Imarticus.
Frequently Asked Questions
What is the role of psychological factors in behavioral finance?
Behavioral finance deals with the impact of psychological factors on investment decisions. Psychological factors explain the inconsistent patterns of the stock pattern including sudden hikes and drops in the price of stock.
What is behavioral finance and the psychology of investing?
Behavioral finance refers to the recognition of biases that contribute to irrational and unpredictable decision-making by investors. Emotions like greed and fear drive the investment decisions of stockholders.
What are the factors influencing financial behaviour?
The factors that affect financial behaviour include financial planning, financial literacy, financial socialisation, and financial skills.
What is the role of Behavioral finance in investment decisions?
Behavioral finance demonstrates how different stockholders assess and react to market trends and data to drive business decision-making.
