The behavioral finance theory states that psychological biases and influences may have an impact on the financial behavior of investors and financial professionals. Financial decisions of investors are frequently influenced by their emotional and physical well-being ,they experience emotional changes when their overall health or wealth either improves or deteriorates. As a result, all real-world problems, especially those related to finances, have an effect on their thinking and decision-making.
Concepts of Behavioral Finance
Typically, behavioral finance includes four key ideas:
- Mental accounting :- filing money into different mental bank accounts that we apply different rules to. There are many ways people go about categorizing money. Often, money is put into “accounts” based on where it came from.
- Herd behavior : – Herding is the process where people choose to follow others and imitate group behaviors rather than making individual, rational decisions based on their own, personal information.
- Emotional gap : – The emotional gap refers to decision-making based on strong emotions or emotional pressures, such as worry, anger, fear, or enthusiasm Emotions are frequently a major factor in why people don’t make logical decisions.
- Self-attribution : – Self-attribution refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution typically results from a natural talent in a certain field, even when their knowledge is insufficient, people often place it higher than others.
Biases in behavioral finances
- Confirmation bias : – is the tendency where investors may only pay attention to data that validates their beliefs about a certain investment. Selectively using information might result in investments that are overly risky and lack of diversity.
For example, a client who is committed to owning shares of a particular company may ignore unfavorable news about that company.
- Experiential bias : – occurs when investors’ memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as recency bias or availability bias.
For example , the stock market was left by many investors as a result of the financial crisis in 2008 and 2009. The fact that they had gone through such a bad experience enhanced their bias or chance that the occurrence might happen again. In fact, the economy turned around and the market recovered in the years that followed.
- Lose aversion : – The tendency to avoid losses over making equal gains. In general, people experience sorrow from losses significantly more intensely than they experience joy from similar-sized gains.
For example , the pain of losing $100 is often far greater than the joy gained in finding the same amount.
- Familiarity bias : – is the tendency of investors to invest in things they are familiar with, such as stocks of local firms or locally held businesses. Investors aren’t diversified across many industries, which can lower risk. Investors frequently choose investments in which they have experience or expertise.
For example , financial instruments such as fixed deposits and PPF are overloaded, whereas the stock market is hardly ever exposed.
Behavioral finance explains how human emotions, biases, and cognitive limitations on the mind’s ability to receive and respond to information greatly influence financial decisions on topics like investments, payments, risk, and personal debt. Behavioral finance offers a guide to assist us in making better & more logical financial decisions by helping us understand how and when people depart from rational expectations.