What is Behavioural Finance?
Behavioral Finance is a field of study that combines psychology and economics to understand how people actually behave in financial decision-making, rather than how they should behave if they were perfectly rational.
According to Behavioural finance, investors’ market behaviour derives from psychological principles of decision-making to explain why people buy or sell stock. Behavioural finance focuses upon how investor interprets and acts on information to take various investment decisions.
Behavioural finance is an add-on paradigm of finance, which seeks to supplement the standard theories of finance by introducing behavioural aspects to the decision-making process. Behavioural finance deals with individuals and ways of gathering and using information. At its core, behavioural finance analyses the ways that people make financial decisions.
Behavioural finance seeks to understand and predict systematic financial market implications of psychological decision processes. In addition, it focused on the application of psychological and economic principles for the improvement of financial decision-making. Behavioural finance is the combination of psychology, sociology and finance.
In addition behavioural finance also places emphasis on investor’s behaviour leading to various market anomalies. Investors fall prey to their own and sometimes others’ mistakes due to the use of emotions in financial decision-making. For many financial advisors, BF is still an unfamiliar and unused subject.
Definition of Behavioural Finance
Sewell has defined Behavioural finance as “the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets”.
Linter has defined Behavioural finance as “study of how human interprets and act on information to make informed investment decisions”.
According to Shefrin, “Behavioural finance is the application of psychology to financial behaviour – the behaviour of investment practitioners.”
Thus, Behavioural finance can be described in the following ways:
- Behavioural finance is the integration of classical economics and finance with psychology and the decision making sciences.
- Behavioural finance is an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature.
- Behavioural finance is the study of how investors systematically make errors in judgment or ‘mental mistakes’.
Behavioural finance is defined as the field of finance that proposes psychological based theories to explain stock market anomalies. Within the Behavioural finance it is assumed that the information structure and the characteristics of market participants systematically influence individual’s investment decisions as well as market outcomes.
Assumptions of Behavioural Finance
- Loss aversion: Loss aversion is a tendency in Behavioural finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains i.e. for them it is better to avoid a loss of ₹500 than to gain ₹500.
- Bounded rationality: The manner in which human being behave, limits the irrationality.
- Denial of risk: They may know statistical odds but refuse to believe these odds.
Nature of Behavioural Finance
Behavioural finance is not just a part of finance but is broader and wider in scope and includes insights from Behavioural economic, psychology and microeconomic theory. In the process of making financial investments, investors often have difficulty while choosing the most economic option because of the impact of his/her various psychological and mental filters. When an investor asks for guidance from an agent or a professional in the field of finance, their behaviour may also be influenced by market information or strategies of other agents or professionals.
Behavioural finance can be defined as open-minded finance. The main theme of traditional finance is to avoid all possible effects of the personality and mindset of an individual. But anomalies and biases existing in the real world are explained with the help of behavioural finance to explain the reasons for the same. As per standard finance theories, investors should be rational in their approach but behavioural finance helps in explaining the normal behaviour of investors.
Types of Behavioural Finance
Behavioural finance, as a subject, can be better discussed if we divide it into two branches which are as follows:
Micro Behavioural Finance (BFMI)
This branch deals with the behaviour of individual investors. In BFMI, we compare irrational investors to rational investors, as observed in the rational/classical economic theory. These rational investors are also known as “homo economicus” or the rational economic man.
Macro Behavioural Finance (BFMA)
Unlike micro behavioural finance (BFMI), which deals with the behaviour of individuals, macro behavioural finance deals with the drawbacks of the efficient market hypothesis. Efficient market hypothesis is one of the models in conventional finance that helps us understand the trend of financial markets.
Macro behavioural finance also addresses the limitations of Portfolio Principles of Markowitz, the Capital Asset Pricing Model (CAPM), Theory of Sharpe, Linter, Black and the Option- Pricing Theory of Black, Scholes and Merton.
Scope of Behavioural Finance
The scope of behavioural finance can be visualized by examining its role in investment decision-making if individuals as well as corporate. The scope areas of behavioural finance are discussed as follows:
- To understand the reasons of market anomalies: Though standard finance theories are able to justify the stock market to a great extent, still there are many market anomalies that take place in stock markets, including creation of bubbles, the effect of any event, calendar effect on stock market trade etc. These market anomalies remain unanswered in standard finance but behavioural finance provides explanation and remedial actions to various market anomalies.
- To identify investor’s personality: An exhaustive study of behavioural finance helps in identifying the different types of investor personality. Once the biases of the investor’s actions are identified, by the study of investor’s personality, various new financial instruments can be developed to hedge the unwanted biases created in the financial markets.
- To enhance the skill set of investment advisors: This can be done by providing better understanding of the investor’s goals, maintaining a systematic approach to advise, earn the expected return and maintain a win-win situation for both the client and the advisor.
- Helps to identify the risks and develop hedging strategies: Because of various anomalies in the stock markets, investments these days are not only exposed to the identified risks, but also to the uncertainty of the returns.
- Behavioural finance provides explanation to various corporate activities.
Objectives of Behavioural Finance
Some specific objectives of behavioural finance have been summarized as follows
- To review the debatable issues in standard finance and to protect the interests of stakeholders in volatile investment scenario.
- To examine the relationship between theories of standard finance and Behavioural finance and to analyse the influence of biases on the investment process because of different personalities playing in the investment market.
- To examine the various social responsibilities of the subject.
- To discuss emerging issues in the financial world.
- To discuss the development of new financial instruments, which have been developed because of the need of hedging the conventional instruments against various market anomalies.
- To familiarize themselves with trend of changes over the years across various economies.
- To examine the contagion effect of various events.
- An effort towards more elaborated identification of investor’s personality.
- More elaborate discussions on optimum asset allocation according to age, sex, income and unique personality of investors.
Application of Behavioural Finance
Behavioural finance actually equips finance professionals with a set of new lenses, which allows them to understand and overcome many proven psychological traps that are present involving human cognition and emotions. This includes corporate boards and managers, individual and institutional investors, portfolio managers, analysts, advisors, and even policymakers.
Behavioural traps exist and occur across all decision spectrums because of the psychological phenomena of heuristics and biases. These phenomena and factors are systematic in nature and can move markets for prolonged periods. It applies to:
- Investors
- Corporations
- Markets
- Regulators
- Educations
Behavioural finance and investment decisions
Decision making is a complex process which can be defined as a process of choosing a particular alternative among a number of possible courses of actions after careful evaluation of each. Most crucial challenges to investors is to make investment decision, having a difference in their profile, like demographic factors, socio economic factors, educational levels, age, gender, and race.
Given the run up in stock (capital) market in 2004 to the end of 2007 and subsequent downturn of financial market, understanding irrational investor behaviour is as important as it has ever been. In present scenario behavioural finance has become an integral part of decision making process due to its influence on performance of investment stock market as well as mutual funds.
Most critical issue is market participant cannot behave rationally always, they deviate from rationality and expected utility assumption while really making investment decisions. So, behavioural finance help investors as well as market participants to understand biases and other psychological constraint in their interplay in market.
Behavioural Biases that Influence Investment Decisions
- Denial: Most of the times investors do not want to believe that the stock they have held since ages has become under-performing or they need to sell it off. They are in a constant state of denial. Even through the said asset brings the overall return of the portfolio down, investors are reluctant to part with it.
- Information processing errors: Often referred to as the heuristic simplification, information-processing error is one of the biases of investor psychology. These people use the simplest approach to solve a problem rather than depending on logical reasoning. Heuristic simplification can be detrimental to the investing decisions. This is done by omitting crucial information to reduce complexity and processing only part information. Such an approach can lead to flawed decisions which can be dangerous to the stock market.
- Emotions: Most of the behavioural anomalies stem from extreme emotions of the investors. This happens when investors do not make decisions with an objective mind and only tend to respond to their biases. Misconceptions, misinterpretations, risk-aversion, past experiences all combine to block the logical bent of mind and exposes the investment decisions to possibilities of risk and losses.
- Loss Aversion: The risk-taking ability of each investor is different. Some are conservative in their approach while others believe in taking calculated risks. However, among the conservative investors are few who fear losses like anything. They may be aware about the potential gains from an asset class but are intimidated by the prospects of incurring even a short-term loss. In short, their excitement for gains is much less than their aversion towards losses. Needless to say these investors miss out on quite a few fruitful investments.
- Social influence/herd mentality: Herding is quite an infamous phenomenon in the stock markets and is the result of massive sell offs and rallies. These investors do not put in deep research behind their decisions and only follow the sentiment of the crowd whether positive or negative. Whether it was the tech bubble in the early 90s, the subprime crisis in 2008, the Eurozone crisis in 2010 or the recent banking sector scams in India, the market has seen huge sell-offs. Most of them weren’t even warranted.
- Framing: According to the Modern Portfolio Theory, an investment cannot be evaluated in isolation. It has to be viewed in the light of the entire portfolio. Instead of focusing on individual securities, investors should have a broader vision of wealth management. However, there are investors who single out assets or a particular investment for evaluation. This is viewing at things through a “narrow frame”. This may lead to losses. Investors need to look at the holistic picture and evaluate with a “wider frame”.
- Anchoring: Many a time investors hold on to a particular belief and refuse to part ways with it. They “anchor” their beliefs to that notions and have difficulty in accepting any new piece of information related to the subject. This is true in cases wherein a real estate or pharmaceutical company is involved in a legal battle or bank has been involved in a scam. This negative information is received with greater intensity, so much so that no other piece of positive information can neutralize its effect.
Approaches to Decision-making in Behavioural Finance
Behavioural finance advocates two approaches to decision-making:
- Reflexive: Following your gut feeling and inherent beliefs. In fact this is your default option.
- Reflective: This approach is logical and methodical, something that requires a deep thought process.
The more investors rely on reflexive decision-making, the more exposed they are to behavioural biases like self-deception biases, heuristic simplification, excess emotions and herding. Behavioural finance is an in depth study on these patterns and is creating a crucial place for itself among investors and investment managers.
To mitigate against reflexive decision-making, it’s important to set up processes. Consider setting up processes that guide you through a logical decision-making approach and therefore help mitigate the use of reflexive decision-making.
Traditional Finance and Behavioural Finance
The key difference between “Traditional Finance” and “Behavioural Finance” are as follows:
- Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioural finance recognises that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their belief and predisposes them to commit errors.
- Traditional finance presupposes that people view all decision through the transparent and objective lens of risk and return. Put differently, the form (or frame) used to describe a problem is inconsequential. In contrast, behavioural finance postulates that perceptions of risk and return are significantly influenced by how decision problem is framed. In other words, behavioural finance assumes frame dependence.
- Traditional finance assumes that people are guided by reasons and logic and independent judgment. While, behavioural finance, recognises that emotions and herd instincts play an important role in influencing decisions.
- Traditional finance argues that markets are efficient, implying that the price of each security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance contends that heuristic-driven biases and errors, frame dependence, and effects emotions and social influence often lead to discrepancy between market price and fundamental value.
- Traditional finance views that price follow random walk, though prices fluctuate to extremes, they are brought back to equilibrium in time. While behavioural finance views that prices are pushed by investors to unsustainable levels in both direction. Investor optimists are disappointed and pessimists are surprised. Stock prices are future estimates, a forecast of what investors expect tomorrow’s price to be, rather than an estimate of the present value of future payment streams.
