Life involves choices, though not always. Sometimes, acceptance is the only option. But for many things, there are choices. You choose, and consequences follow. How do you decide? What guides your choice?
Do you always use numbers and technical tools to make decisions? Or do you use your personal experiences and perspectives while making decisions? Or do you use a combination of both?
People are usually calculative concerning decisions involving money. But, there are cases where you let your personal opinions take over facts and data, even about money matters. In today’s article, we will discuss how emotions take over practicality when it comes to investment decisions through the concept of behavioural finance.
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What is behavioural finance?
It is essential to know the meaning of behavioural economics to understand the meaning of behavioural finance.
Behavioural economics is a branch of economics that involves psychological theories to analyse human behaviour and reactions to various events in the real world.
When behavioural economics is applied to the field of finance, it is called behavioural finance. It helps in analysing the psychology behind financial and investment decisions.
The nature of behavioural finance
It is noteworthy to touch on the concept of traditional finance here. According to theories of traditional finance, investors are rational, and their decisions are purely driven by logic and reasoning. It also believes in the efficient market hypothesis that states the market is efficient in capturing all relevant factors and reflecting them in prices.
Behavioural finance is the reverse of this. It believes that human decisions do not have to be rational and driven by facts at all times. According to behavioural finance, decisions are also driven by emotions to a large extent. It disputes the efficient market hypothesis as prices may be due to biases and may not reflect market sentiments.
The scope of behavioural finance biases in investing decisions
What forms biases in the minds of individuals? There are various reasons for this. Sometimes, it is the effect of incorrectly assessing your skills and not knowing enough to make rational choices. Other times, it could be a result of social influences and the pressure to follow your peers.
Below are some biases that influence investing decisions:
Confirmation bias
Have you heard of selective listening? It is where you listen to what you want and leave the rest. Confirmation bias is similar to that. It is where investors choose to consider facts and data that match their beliefs and ignore those facts that do not complement their thoughts. There is a high chance of errors in investments made with this bias.
Example: You are bullish about a specific stock and expect its prices to increase. During your analysis, you will tend to look for data and facts that show potential increases. You will ignore all those warnings that may indicate the possibility of a price decrease.
Herd mentality bias
Herd mentality is to follow the herd. It is the result of social influences. It is where investors blindly follow their fellow investors rather than relying on their analysis. The rise of financial influencers who advise on what to do and what not to do has a large impact on the minds of investors. It is possible that investors go by the suggestions of these influencers rather than applying their skills.
Example: You decide to buy a stock just because your friend bought it once and earned profits. Your risk-taking capabilities might not be as high as your friend’s. You still invest without measuring your risk potential.
Loss aversion
This bias is driven by the conservative mindsets of investors. It is where an investor is more worried about the possible losses than being prepared for potential profits. Investors may miss several profit-making opportunities due to this mindset.
Example: Consider two investment opportunities where one is risk-free and offers minimum returns, while the second opportunity involves a small degree of risk but offers high returns. The investor who is averse to risk chooses the first option and lets go of the extra returns for fear of loss.
Also read: Risk management in stock market
Overconfidence of investors
It is where investors do not know what they know. They over-assess their capabilities and make investments that they feel are right instead of depending on facts.
Example: A technical analysis shows that the price of a stock is expected to fall. You ignore it because you think it will rise.
Familiarity bias
It is where investors are not open to experiment. They refrain from trying their luck at different investments and stick to the ones they are familiar with. Diversification may become difficult due to this, leading to more exposure to risk.
Example: You have been investing in large-cap stocks because they provide stable income. You continue to do so and ignore small-cap stocks even if they are more profitable because you have not tried them in the past.
Overcoming biases
Below are some steps investors can take to overcome behavioural investing:
- For newcomers in the financial markets, investing can be more favourable than trading. So, novice investors must spend sufficient time investing and understanding the market to pick up the required skills before beginning to trade.
- Understanding one’s financial goals and risk tolerance abilities is the key to overcoming biases while making investment decisions.
- Relying on the advice of specialists in the field of finance is better than relying on influencers on social media. So, novice investors must seek advice from professional financial advisors.
- It requires investors to make a shift in their mindsets from relying on emotions to deciding based on data and facts. So, investors must invest based on prevailing market conditions rather than past experiences.
Also read: Decode the sentiments of the market to devise successful trading strategies.
Bottomline
The irrational side of investors taking over their rational decision-making ability encompasses the concept of behavioural finance. While there are numerous tools to analyse stocks in both fundamental and technical methods, there is a significant role that the emotions of investors play. It is not easy for investors to ignore these biases and rely on rational thinking. However, it is essential for them to balance the two for the best returns.
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