INTRODUCTION TO BEHAVIOURAL FINANCE

Introduction

For decades, psychologists and sociologists have pushed back against the theories of
mainstream finance and economics, arguing that human beings are not rational utility-
maximizing actors and those markets are not efficient in the real world. The field of behavioral
economics arose in the late 1970s to address these issues, accumulating a wide swath of cases
when people systematically behave “irrationally.” The application of behavioral economics to
the world of finance is known as behavioral finance. At times, investors lack self-control, act
irrational, and make decisions based more on emotions than facts. The study of these influences
on investors and markets is called behavioral finance.

Meaning & Definition

Behavioral finance is the study of the influence of psychology on the behavior of investors or
financial analysts. It also includes the subsequent effects on the markets. It focuses on the fact
that investors are not always rational, have limits to their self-control, and are influenced by their
own biases.

Behavioral finance refers to the study focusing on explaining the influence of psychology in
the decision-making process of investors. It explains the occurrence of irrational decision-
making in the financial market when it is expected to be a manifestation of rational decisions
and an efficient market.

The relevance of psychology in financial planning is increasing. Financial advisors combine

traditional concepts with elements of behavioral finance theory while developing strategies to
strengthen the client relationship.
Nature of Behavioural Finance

 Behavioral finance is a subfield of behavioral economics, which argues that when making
financial decisions like investing people are not nearly as rational as traditional finance
theory predicts.
 Behavioral finance is the study of understanding people’s irrational financial decisions.
 The two main building blocks are cognitive psychology and the limits to arbitrage.
 Some of the biases affecting financial decisions are confirmation bias, disposition bias,
experiential bias, familiarity bias, loss aversion, mental accounting, and overconfidence.
 Understanding the psychological bias influence can help investors understand the market
behavior and make better investment decisions.
 Businesses using the combination of traditional and behavioral finance theories to generate
effective client management strategies are increasing

Biases of Behavioral Finance

Biases play a major role in an entity’s financial decision-making process. Behavioral finance
seeks an understanding of the impact of personal biases on investors. Here is a list of common
financial biases. Common biases include:

1. Confirmation Bias
2. Familiarity Bias
3. Self Attribution Bias
4. Hindsight Bias
5. Heuristic Bias
6. Anchoring Bias
7. Mental Accounting
8. Herd Behaviour
9. Emotional Gap
10. Experimental Bias
11. Loss Aversion
12. Overconfidence and illusion of control
13. Disposition Bias
Confirmation Bias:

The confirmation bias occurs when the investors align to the information that matches with
their beliefs. The data could be wrong, but as long as it fits with their views, they end up
relying on it. Confirmation bias describes an investor's or individual's tendency to easily
accept information they already believe to be true. This usually means an individual finds
extra reasons to prove their preconceived idea, rather than conducting accurate research. It's
important to acknowledge confirmation bias because it can prevent professionals from
trusting information that may be wrong but fits their opinion.
Familiarity Bias:

Familiarity bias describes the tendency for people to invest in only companies or assets they
already know, preventing them from taking risks or participating in innovative investments.
It's important for professionals to recognize familiarity bias and advise against it for their
clients and investors to make financial decisions that promote diversity and profitable risks.
For example, a financial advisor might encourage their client to invest in an innovative startup
instead of the same types of businesses in which their client has the most familiarity. The
familiarity bias is reflected when investors place their investment in the stocks from the
industry they know and understand rather than going after securities from an unrelated field.
In this process, they may lose new or innovative opportunities that are revolutionary.
Self-Attribution

Self-attribution is the tendency for someone to make decisions based on an overestimation of

their skill. This can mean someone considers their knowledge above the level of other
professionals. This bias could lead to incorrect decision-making because it doesn’t factor in
outside influences and expertise. People can avoid self-attribution by listening to the advice
of financial professionals and researching the possible outcomes of a decision before committing
to it.

Hindsight Bias
Hindsight bias encourages individuals to overvalue their educated guesses when, in reality, their
success could have been a coincidence. For example, if an investor sells a stock right before the
price declines, the investor may believe they knew the stock would decrease, rather than credit
the actual reasoning behind their decision. Hindsight bias can affect the financial analysis
process because it credits causes for certain practices that aren't necessarily relevant or accurate.

Heuristic Simplification

Heuristic simplification is an example of cognitive bias that causes professionals to oversimplify

their decision-making process. This can lead to professionals making financial decisions based
on incomplete or inaccurate data. Heuristic simplification bias might cause an individual to
consider only some of the information relevant to their decision or allow them to be
overconfident in their own knowledge, ignoring the expertise of finance professionals. It's
important to do thorough research and consult professionals before making financial decisions to
recognize and overcome heuristic simplification bias.
Anchoring

Anchoring is based on the fact a benchmark price has a disproportionately high influence on an
individual's decision-making. For example, if a professional sees a certain stock costs $100, they
may use that purchase price as a reference for how much the stock’s actually worth. Anchoring
can cause them to stay fixated on that number, ignore other indicators of value and adjust their
beliefs and actions accordingly.
The individual may assume the market price is the correct price, which can make them base new
decisions on old information. This may result in selling an overachieving stock while keeping an
underachieving one and taking the losses.

Mental Accounting:

Mental accounting is the tendency for individuals to save and allocate money for specific
purposes. Based on subjective criteria, this could cause individuals to place different values
on the same amount of money. Because people classify funds differently, this may cause
irrational or irregular financial activity, such as finding a low-return savings account while
carrying large credit card debt. To compensate for mental accounting, many finance
professionals encourage their clients to recognize this bias and assign equal value to equal
sums of assets. People’s budgeting process or spending habits may vary based on
circumstances. That is, they don’t maintain a consistent pace. For instance, people may spend
for luxury in a mall or while on vacation, and they also possess a modest lifestyle at home or
when they are back from vacation.

Herd Behavior
Herd behavior refers to the tendency for individuals to follow others’ financial decisions,
instead of doing their own research and analysis. For example, if a person notices others are
investing in a certain stock, it may motivate them to do the same. To avoid herd behavior,
individuals could do their own research to make financial decisions and measure their risk.
Historically, herd behavior can start large sell-offs and market rallies in the stock market

Emotional Gap

An emotional gap describes when an extreme emotion motivates an individual's financial

decisions. In finance, the emotions that often comprise an emotional gap are anxiety, greed,
enthusiasm and fear. These are the key reasons people make irrational decisions. Fear and greed
can harm portfolios, affecting the stability of the stock market and the economy. Finance
professionals often strive to advise individuals against these trends, offering long-term plans
based on firm fundamentals and rational advice.

Experiential Bias:

It occurs when an investor’s memories or experiences from past events make them choose
sides even when such a decision is not rational. Also known as a recency or availability bias,
an experiential bias occurs when professionals allow recent events to influence their actions
and opinions about a topic or practice, even if it’s irrational. Experiential bias can cause
individuals to believe something’s more likely to happen than it actually is.

For example, if an investor takes a risk and invests in an online marketplace startup, they
may be less likely to invest in a similar business in the future if the startup doesn't perform
well. This is an experiential bias because a startup may not work for a variety of reasons,
making it inaccurate to judge all others.

Loss Aversion:

Loss aversion makes investors avoid taking a risk even if it earns high returns. They give
priority to restraining from experiencing losses rather than experiencing high returns. Loss
aversion occurs when an investor places more value in avoiding risks than on gaining money.
This bias encourages them to make only safe decisions in which there’s little or no risk of
losing money, waiting to get back to the original amount they paid for the asset before
reselling it. For example, if an investor bought a stock for $100 and the value of it then
dropped to $80, loss aversion bias may cause the investor to hold on to the stock for longer,
hoping to earn at least what they originally paid before selling.

Overconfidence:

Overconfidence reflects when investors overestimate their abilities or trading skills and make
decisions forgoing factual evidences.

Disposition Bias:
It explains the propensity of investors to hold on to the stocks even if the prices are declining,
believing that the prices will appreciate in the future and, at the same time, sell the well-
performing stocks. Such investors tend to hold on to a stock losing money, hoping that the
price will soon increase. In their minds, it’s only a matter of time before the tides change for
them, and they can then make profits on all their positions in a market.