Behavioral finance is a relatively new field of study to see how psychology and emotions influence financial decision-making. This field of study has grown in popularity recently as researchers have begun understanding how our emotions and biases can impact our financial decisions.
As rightly explained by Hersh Shefrin, “Behavioural finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets.”
One of the most well-known biases in behavioral finance is the “herd mentality.” It refers to a situation when people follow the actions of others, even if it goes against their best interests. For example, during a stock market boom, people may invest in stocks simply because everyone else is doing so, even if it is over-valued. In recent years, there has been a trend among retail investors in India to participate in IPOs in large numbers, driven by the belief that investing in newly-listed companies can lead to quick profits. That has led to a situation where IPOs are often oversubscribed by many times, with retail investors eager to get their hands on a piece of the action.
Another bias that can impact financial decision-making is “loss aversion.” It is the tendency for people to strongly prefer avoiding losses to acquiring gains. That can lead to people holding on to losing investments for too long or selling winning investments too early.
Other biases which impact our financial decision-making include overconfidence, optimism bias, and the sunk cost fallacy.
Overconfidence can lead to people taking on too much risk, while optimism bias can lead to underestimating risks. The sunk cost fallacy is when people continue to invest in a project or venture because they have already invested a lot of time or money into it, even if it is not likely to be successful.
Another example of a bias in investing is the “recency bias.” It occurs when investors give more weight to recent events when making investment decisions rather than considering longer-term trends. For example, an investor may see that a particular stock has performed well in the past few weeks and decide to buy it without considering that the stock may have performed poorly over the past year or longer. This bias can lead to poor investment decisions as it may cause an investor, to overlook important information and make decisions based on short-term fluctuations rather than long-term potential.
Terrance Odean elaborated the science as ‘Behavioral finance is the study of how psychological, social, cognitive, and emotional factors influence financial decision making, and how this, in turn, affects individual and market outcomes.
So, how can we overcome these biases and make better financial decisions? One solution is to seek a financial advisor or professional who can provide objective advice and help us make more rational decisions. Additionally, it can be helpful to use tools like budgeting and goal setting to create a clear plan for our finances. Also, learning about the different biases that can impact our decisions and being aware of them can help us make more informed decisions.
In conclusion, it’s necessary to understand that our emotions and biases can impact our financial decisions. When it comes to finances-by being aware of these biases (by developing the correct mental models) and seeking objective advice-we can make more informed and rational decisions.
