BEHAVIOURAL FINANCE – (Definition, Importance & Themes)

INTRODUCTION

BEHAVIOURAL FINANCE!!! Well, just as the name suggests, yes it basically deals with how typically human beings behave when it comes to handling different financial decisions. However, it is not that simple and as such, there is an entire subject dedicated to behavioural finance. But, strangely the subject was not officially recognized only until the year 2002 when Daniel Kahneman was awarded the Nobel Prize in Economic Sciences. He is one of the founding fathers of behavioural finance. I think the mere ignorance of the subject per se until so late speaks volume about strong human behavioural bias. Unlike a classical financial theory, behavioural finance expects individuals to be more influenced by their emotions or reasonable biases rather than taking the rational approach. There are a large number of brains who are not quite willing to accept this discipline as it is often found to be more complex, instinctive, abstract etc. Further, the denial for the discipline is also because it can create doubt in the minds of many about the decisions of sophisticated investors and professional advisors.

IMPORTANCE OF BEHAVIOURAL FINANCE

The prevalence of behavioural finance in our society was very beautifully demonstrated by John Keynes who was a British economist. In 1936, he stated that market behaviour is analogous to the behaviour of the individuals who have to choose the winner at a “beauty contest”. In a beauty contest, the judges select that person as the winner whom his/her peers are likely to select, i.e. the judges are not interested in picking the most beautiful face, but they rather concentrate on selecting the one who is likely to please the other judges. If you notice carefully, you will see the investors use a similar approach of “consensus” wherein they all combine their expectations and act in unison. On the other hand, there are investors who are likely to trade on stocks that are expected to beat the consensus and avoid those stocks whose market value is considerably less than the fundamental value as per the consensus. Therefore, the concept of behaviour is applicable from the moment investors attempt to spot the future behaviour of fellow investors.

Themes OF BEHAVIOURAL FINANCE

Now that you have been familiarised with the basic concept of behavioural finance, let me introduce you to the four major themes of behavioural finance: over-confidence, financial cognitive dissonance, regret theory and prospect theory.

• Over-confidence:

How often do we come across people who apparently over-estimate their own skills and predictions for success. The behaviour of such people is defined to be over-confidence which eventually results in over-estimation of the probable outcomes of an event. Now one such friend of mine is Tarun who is an active investor with long standing experience, but has suffered several losses in the past primarily due to his over-confidence. But what is more disturbing is that he refuses to learn from his previous failed investment decisions.

• Financial Cognitive Dissonance:

It is another theory which states that people often feel anxious when they are subjected to their own conflicting beliefs. Most of the individuals try to bring down their inner conflict in either of the two following ways:

1. 1. They alter their past values, feelings or opinions.

1. They try to rationalize or justify their choice.

This theory can be applicable to many of my friends who are traders in the stock market and are required to rationalize their conflicting behaviours in order to make it look as if it followed naturally from their personal values.

• Regret theory:

According to this theory an individual usually assesses his expected reactions to a future event or situation based on some regret of the past. The theory can be associated with the emotion instigated by comparison of a given outcome with the outcome of a foregone choice. For instance, Trevor had to decide between investing in an unknown stock and a well-known stock. As an investor he knew that the known stock would give lower return than the unknown one, but he decided to go with the known stock because he is more comfortable with the regret of finding that the unknown stock performed better than the known stock.

• Prospect Theory:

On the other hand, prospect theory states that people usually do not behave rationally. So you might come across people who hold onto persistent biases that are motivated by several psychological factors that are triggered under conditions of uncertainty. One such personality is Rishab who considers preferences as a function of “decision weights”, but his decision weights tend to overweight small probabilities and underweight moderate and high probabilities which eventually does not quite help his case.

FEW DECISION MAKING BIASES AND ERRORS

Behavioural finance also covers various decision-making biases and errors and few of them are discussed below:

• Self-deception: We usually meet people who tend to limit their learning abilities due to self-deception. They are your those colleagues who think they know more than you and as such are not receptive to information that might be required to make an informed decision.

• Heuristic simplification: This bias is again associated with people who take into account incorrect and erroneous reasoning or adopt a wrong behaviour to arrive at a decision.

• Emotion: How often do we make a decision out of anger, happiness, ecstasy etc. I am sure we all tend to have many such instances in our day-to-day life. But this is basically how our moods affect our decision making.

• Social Influence: As a social being, most of our decisions are largely impacted by our peers which may include investment in a stock because most of our friends invested in that.

Conclusion

So, what can be said is that people are not always rational just like the market is not always efficient. Behavioural finance helps us in understanding why people usually do not make the decisions that they are supposed to, just like why the market acts unreliably at times. There are several researches which vindicates that a large number of investors make decisions not based on logic but emotion which is usually seen in cases where the investors purchase stocks at higher price based on speculation and then sell off at lower price under panic. So, behavioural finance helps us in avoiding the decisions driven  by emotion that ultimately leads to losses. While it is difficult to prove that it actually contributes in improving the performance, but it is easy to understand that there are certain biases that influence our investment decisions. Although it is impossible to eradicate them altogether, you should take steps to recognize your biases and safeguard yourselves from its shortcomings.