Sometimes it is useful to borrow principals and ideas from other fields to help better understand your own area of research. When experts in finance use methodology from psychology to help better understand the behaviour of investors and others in the field of finance, this falls under the category of ‘behavioral finance’.
Behavioral finance is a field of study which analyses the effects of psychological influences and biases on the financial behavior of investors and financial markets. It explains why investors sometimes lack self-control and act against their own interests while making investment choices. Moreover, these influences and biases can even occur across a wide scope of people and affect financial markets drastically. Particularly, the stock markets, where severe rises and falls in stock prices can be observed affecting a variety of industries and sectors.
The following are the traits of behavioral finance theory:
● Investors are considered “normal”, not “rational” people. This means that investors too can lack self-control.
● They are influenced by personal biases and do not always rely on facts. This can influence investment decisions.
● They can make cognitive errors that can lead to wrong choices which can have consequences on the market as a whole.
This is in contrast to the traditional financial theory, where investors are considered to be perfectly rational — they are those who have complete self-control and are not confused by cognitive errors.
Causes of decision-making errors
Now that we know certain biases and psychological influences can affect investment decisions, let’s see what causes those biases in the first place.
Self-deception
Self-deception is thinking we know more than we actually do. Thus, we tend to ignore information that is required to make the right decision.
Heuristic simplification
This refers to the simplification of complex problems than can lead to misunderstandings.
Emotion
Sometimes, people make investment decisions based on their current emotional state. This often leads them to lose rationality while coming up with a decision.
Social influence
This refers to the influence other people’s opinions have on our investment decisions.
Understanding biases in behavioral finance
The most common financial biases which lead to inaccurate decisions are described below:
Confirmation bias
This bias means that you pay more attention to information that confirms an already-held belief in an investment, while ignoring any other information that contradicts that belief.
Self-attribution bias
The belief that good investment outcomes are a result of your skill, whereas bad ones are due to sheer bad luck.
Familiarity bias
Such bias occurs when investors tend to go with investments they know or have a history with. This leads to investors not diversifying their portfolios, which can reduce their risk.
Representative bias
This bias results from believing that two events or things are more closely associated with each other than they really are.
Loss aversion
Your focus is on avoiding a loss rather than recognizing an investment opportunity.
Framing bias
When investors make a decision based on the way an investment opportunity is presented to them rather than the facts, they are subjected to framing bias.
Anybody can fall prey to these biases while making an investment decision. To overcome these behavioral tendencies, you should adopt a reflective and methodical decision-making process, instead of going with a reflexive one.
Behavioral finance helps in the effective financial management of your money. People who have retired or are about to retire have to look at the big picture and indulge in retirement income planning to secure their future. They are advised to learn about these biases and not get trapped in them while making investment decisions for themselves.
At Hampton Wealth Management, we help individuals and organizations to get more educated in finance, and to meet their financial goals. Get in touch with our advisors to secure your financial future!