This article will cover all the aspects of Behavioral Finance, so make sure to stick around for it.
As an investor, you are always looking out for news and events happening in the market. Many times, there is news where the media states that the market is crashing because of some rumor going in the market.
This happens when the actions of one investor are followed by the majority of the market participants, like a herd. Or if a share is overvalued and you are waiting for it to get down to its fair price but instead it keeps on increasing and the overvaluation keeps on going up.
All these events are the result of behavioral finance. The sentiments of the market play a very important role in the movement of the market.
Now, this can be for the better or worse, thus, many times differentiating the right and wrong market behavior is important to protect your profits.
Idealized Finance vs. Behavioral Finance
Let’s assume that all the finance strategies and theories studied in the textbooks are referred to as idealized finance.
For such circumstances to happen in the real world, the market needs to be unbiased, and rational and have a participant who has perfect information. Now, we all know that this is not true and is not easy to achieve.
Because in reality, the market is neither perfectly informed nor has every participant capable of making analyzed and informed decisions. The movement in the market involves a lot of emotional factors.
And all these factors together impact the market in a less rational manner leading to market biases and herd behavior. The study of these factors is known as behavioral finance.
Thus, it can be said that behavioral science is the combination of behavioral psychology and finance.
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What is Behavioral Finance?
Behavioral finance is a theory that points out that other than economic factors there is also psychological influences on the movement of the market.
There are a lot of professionals who point out that the reason behind multiple abnormalities in the market, such as a sudden change in stock price or rise in demand for an asset, is the result of behavioral finance.
Behavioral economists are straight-out pointing out that a market is a place filled with people with multiple perspectives and not every perspective is based on rational thinking.
Many times, the tendency to reduce risk or avoid challenges, the investors might end up making decisions that might not be informed and are based on psychological factors.
What is the main cause of Behavioral Finance?
One of the main reasons behind these psychological biases comes from market prediction. Usually, in other aspects of life, prediction does not lead to actions, such as making a weather prediction will not lead to any change in weather.
However, if a seasoned investor likes Warren Buffet, states that the market is going to experience a downturn, then this will grow fear among the investors.
And the spark that this fear sets off will lead to an actual fall of the market as investors start selling their assets to protect their profits.
Therefore, the prediction becomes a reality. And the only reason why predictions of the share market become true is because the space is home to human minds which get impacted by every movement and event around them.
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Major Concepts of Behavioral Finance
Now, that it is clear what behavioral finance is, let’s check the different segments into which it is divided:
You must have seen animal herds right, and the reason why the crowd is termed as a herd is that all of the animals move in the same direction. This same mentality works in the financial market as well.
For instance, if someone sees that others are buying a particular stock, they can be inspired to do the same. Herd behavior has historically caused significant stock market sell-offs and market rallies.
Individuals sometimes incline to save aside money and allocate it for particular goals. People tend to assign various values to the same sum of money based on subjective standards.
This kind of thinking can lead to irrational and unpredictable behavior. For example, to compensate for credit card debt, the investors will invest in any low-return savings account.
Professionals always advise that to feed into the mental accounting, remember to put equal value to an equal sum of money.
Self-attribution refers to a person’s inclination to make decisions based on an overestimation of their ability. This could imply that someone believes their knowledge to be superior to that of other experts.
And between this cycle of overestimation, investors may ignore important indicators and end up making incorrect decisions. Thus, it is never bad to take a second opinion from an expert as it will solidify the profits.
Anchoring is the term used to explain the unconscious use of irrelevant data, such as the price at which a security was purchased, as a fixed reference point (or anchor) for future decisions regarding that asset.
The person may base their selections on outdated knowledge since they believe the market price to be the appropriate price. This could lead to the sale of a stock that has performed well while holding a stock that has performed poorly and taking losses.
The emotional gap indicates the mentality when an investor makes investment decisions influenced by their emotional inclination. Anxiety, enthusiasm, greed, and fear are the feelings that frequently make up an emotional gap in finance.
These are very strong emotional tangents that can lead to multiple illogical decisions. it is highly advised that investors should steer clear of any kind of emotional decisions and should have logical and quantitative analysis to back their trading decisions.
Benefits of Behavioral Finance
As psychology is important to understand the thinking process of any human, behavioral finance is required to understand the thought process of investors when they were making a certain investment decision.
So, in the following ways behavioral finance benefits the market:
Differentiate between rational and irrational decisions
By understanding the basis for trading decisions, professionals will be able to differentiate between rational and emotionally biased moves.
This can also be used to educate investors on how they can avoid irrational decisions by relying on facts and not emotions.
Overcome herd behavior
The market is almost run by herd behavior, actions of one prominent investor lead to the entire market following the same direction.
If you as an investor have exposure to behavioral finance, you will know that before making any decision, it is best to first perform individual analysis. You never know when you might be letting go of grub by just following some uninformed crowd.
Create buy and sell opportunities
If you are aware of the principles and concepts of behavioral finance, you will be able to identify when it happens in the market.
And you can use this information to your advantage and create buy and sell opportunities for yourself. The earlier you can identify these biases, the higher profits you will be able to pocket.
The truth is that conventional financial theories fall short in explaining many market phenomena and are therefore insufficient. Therefore, investors need to consider the behavioral factors that influence decision-making.
No matter how much irrational element investor emotional behavior brings to the share market, there is no denying that it still rules the place.
So, the best thing that you can do is educate yourself about it and turn the irrational events to your advantage.
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