Behavioral Finance

 

“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble

 -Warren Buffet

Behavioural finance, a subfield of behavioural economics, proposes that psychological influences and biases affect the financial behaviours of investors and financial practitioners. It focuses on the fact that people are not always rational, have limits to their self-control,  and are influenced by their own biases for example in markets with manipulative prices sometimes and invests maximum without any logical basis solely on behavioural nature. Moreover, influences and biases can be the source for explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or  falls in stock price. Behavioural finance seeks an understanding of the impact of personal biases on investors.

Common biases include: Overconfidence and illusion of control, Self-Attribution Bias, Hindsight Bias, Confirmation Bias, The Narrative Fallacy, Representative Bias, Framing Bias, Anchoring Bias, Loss Aversion and Herding Mentality.

Relying on reflexive decision-making makes us more prone to deceptive biases and emotional and social influences. Establishing logical  decision-making  processes  can help protect one from such errors. Behavioural finance teaches us to invest by preparing, by planning, and by making sure we pre-commit.

There are likely several different areas of behavioural finance that will shine in the coming years. The first area is wealth and investment management. Advisors must be  able to both understand the behavioural phenomena present in prices as well as the behavioural biases and heuristics present in their clients. As a result, there is to be increased research done on individual investor biases until there is the creation of a somewhat standard test for investor biases. Nonetheless, behavioural finance is still young and is only now beginning to make its way into mainstream academia, industry  and society. Behavioural finance is rapidly growing in prominence and practice, and there are both risks and benefits inherent in that fact. The most obvious risk lies in unethical applications of the research. If behavioural finance has taught us anything in the last decades, it’s that negative outcomes are often far more vivid and powerful than positive ones. There is a risk in the immoral applications of this research, such as exploiting people’s biases for profits. Despite the risks, behavioural finance will continue to  flourish. It will prove to be useful in classifying investor biases, arbitraging market irregularities and inconsistencies, which in turn, will promote the development of tools and techniques to avoid and overcome the same.

An extract of an article from The Economic Times, by Stephen Wendel, reads, “Behavioural finance can and should be a vial tool to leverage research and software, in the broader industry, to help investors reach their financial goals.”

“Behavioural finance can and should be a vital tool to leverage research and software, in the broader industry, to help investors reach their