Executive Summary: While conventional financial concepts give a backing to finance and assumes that one would take logical financial decisions, it has been found that many a time people take irrational decisions in the real world. These irregularities are explained by emotions and behaviours which govern the way decisions are taken. Behavioural finance is a study of such psychology based theories to understand irregularities in financial decisions. It is important to be cognizant of behavioural aspects which determine decisions, in addition to conventional finance.
Theoretically, it is assumed that while making investments, men follow rational behaviour and try to maximise their wealth from the investment. This is based on conventional financial concepts, where one acts logically to gain the most from a financial action. However, over time, it has been found that these financial concepts and theories are not applicable completely in the real world. It was found that these variances are based on certain behaviours by investors in the real world, which is driven by emotions and other factors. It was established that such irrational behaviour is perfectly normal and occurred naturally in the real world. These findings led to looking at behaviours more closely while evaluating financial actions and reactions.
What is behavioural finance?
Behavioural finance uses psychology based theories along with finance concepts to explain why irrational decisions are made in the area of finance. An irrational decision causes irregularities in what is expected to be the outcome of a financial action. The term used to describe these irregularities is ‘anomalies’, wherein an anomaly is believed to violate conventional principles and theories of the financial world. Some of the popular anomalies found in financial theories are (a) The January Effect, (b) The Winner’s Curse and (c) Equity Premium Puzzle. Some important contributors to the study of behavioural finance are Daniel Kahneman, Amos Tversky and Richard Thaler. The concept of behavioural finance has been explained in simple terms in this video.
Applicability of behavioural finance
Behavioural finance is most used to understand movements in the stock markets. An important area where behavioural finance is most applicable is to understand how prices of stocks move in the equity markets, even when there is no corporate action announced by the particular company in question. There is reaction by investors based on emotions and behaviours resulting in a change in prices and returns on stocks, although there may not be a solid financial reason backing the action.
Experts cite 8 key concepts in behavioural finance which explain the irrational behaviour of investors. These concepts are supposedly responsible for the incorrect financial decisions taken by investors, which have no backing of financial theory. The 8 important concepts are - Anchoring, Mental Accounting, Confirmation and Hindsight Bias, Gambler’s Fallacy, Herd Behaviour, Overconfidence, Overreaction and Availability Bias and Prospect Theory.
Why should you be worried about behavioural finance?
Financial experts had for long believed that having a sound understanding of financial concepts was fairly a sufficient reason to predict stock market movements. However, over time, it was discovered that behavioural aspects of investors were a strong determinant of how the price of a particular stock moved. It was also discovered that other investors in the market took advantage of such ‘errors’ which took place in conventional financial concepts. As a direct or indirect (through mutual funds) investor in the stock markets, you would also be affected by concepts of behavioural finance. As the video in the link above explains, behavioural finance is also applicable in other areas of financial decisions in our lives, in addition to investments. It would therefore be important for you to understand key concepts of behavioural finance and view this in conjunction with conventional, established financial theories while making financial decisions.
While behavioural finance has gained popularity over the years, it has received its share of criticism by conventional finance practitioners. As a common man, it would be prudent to be cognizant of the existence of behavioural finance and not rely solely on conventional finance concepts. In the coming weeks, we will be discussing more on some of the important concepts of behavioural finance.
While the above post is original, concepts have been sourced from Investopedia.com