Behavioural Finance
To understand the meaning of behavioural finance, let’s first understand the meaning of behavioural science. Behavioural Science is the study of how a person reacts in a particular situation; it has nothing to do with the stock market but is rather about one’s personal way of living.
There are three friends named A, B, and C. B met with an accident and his leg got fractured. C called B and asked about the situation, and B explained what had happened. To B’s reply, C said it’s very sad that it happened to you and now you have to face trouble because of this.
The next call B received is from A, who also asked about the situation, and to B’s reply, he said thank God nothing worse had happened and had fun with B over the call.
Both situations are a part of behavioural science, but the outcome of both is totally different. In stock markets, we call them Bull (A) and Bear (C).
Definition
Behavioural Finance is how a person is bound to react in a certain situation, which could result in sentiments/reactions, ultimately translating into market sentiments.
Behavioural Finance is based on the emotion of people which they adopt from bounded rationality, meaning what they think is right, but markets don’t work like this. Thus, we need to follow Standardised Finance, which is not based on emotion but on systems, discipline, and rules.
Difference between Standardised Finance and Behavioural Finance
| Aspect | Standardised Finance | Behavioural Finance |
| Focus | Macro Studies | Micro Studies |
| Decision Basis | Decisions guided by economics | Decisions guided by emotions |
| Approach | Studies future economy, business, history, and growth | Studies current situation and personal goals |
| Trading Style | Rule-based trading | Emotion-based trading |
Note: History suggests the best fund managers are those who excel in both branches of finance.
Parameters of Behavioural Finance
Confirmation Bias
Confirmation bias is the bias an investor/trader has, where they confirm their decision because they have researched and predicted the future of their investment based on the information they have, even if it is flawed.
Experiential Bias
Experiential Bias is the bias an investor/trader has based on previous events they have seen, predicting that it will happen again. For example, after the bull run of the crypto market in 2021, where the bitcoin price fell to $16,000 and then recovered to $69,000 and touched an all-time high in 2024 before halving, an investor keeps waiting for the dip to $16,000 because they have seen the market crash before halving, but in reality, the market didn’t fall and the halving is done.
Loss Aversion
Loss Aversion is the greed of the investor to have more returns always. In this case, investors/traders place a greater weighting on the concern for losses than the pleasure of market gains.
For example: An investor invested in an underlying asset with a target of a 20% return, which they achieved in a single day, but they think it will rise more because they got 20% very quickly. In reality, they know the price of the underlying asset will be overvalued if it rises by only 1%. But this parameter pushes them to greed, for which they are ready to lose 20%, which was their target.
Then suddenly, due to market volatility, the asset went 30% down, and now they have a 10% loss. In this parameter, most investors are reluctant to admit that they made a mistake.
Familiarity Bias
Familiarity Bias is the bias an investor carries based on investing in businesses, companies, or assets they are already familiar with. In this parameter, investors mostly invest on the basis of their previous investment where they are sure, leading to very low-risk investments. For example: Investing in Fixed Deposits where risks are very low and it’s proven with a guaranteed rate of return.
Also Read: Psychology of Bull and Bear Markets
Untold truth of Behavioural Finance
When prices of commodities go up, demand for that particular commodity goes down. On the other hand, if the prices of equity shares go up, demand for equity shares also goes up (due to certain parameters of behavioural science). We guarantee you this truth is not mentioned in any book or theory in the entire world.
Please understand that every human being is a rational human being, which means we have patterns of reactions based on our knowledge. Therefore, it is essential to gain knowledge every second in order to escape the bounded rationality of our mind.
FAQ
Q1: How can an investor mitigate the effects of confirmation bias? A1: Investors can mitigate confirmation bias by seeking out diverse opinions, conducting thorough and unbiased research, and considering data and information that contradict their initial beliefs.
Q2: What role do emotions play in market bubbles and crashes? A2: Emotions like greed and fear can lead to market bubbles when investors irrationally drive prices up, and to market crashes when panic selling occurs. Behavioural finance studies these emotional impacts on market dynamics.
Q3: How can understanding behavioural finance improve investment strategies? A3: By understanding behavioural finance, investors can identify and control their own biases, leading to more disciplined and rational decision-making, potentially resulting in better investment performance.
Q4: What are some common psychological traps investors fall into? A4: Common psychological traps include overconfidence, herd behavior, anchoring (relying too heavily on the first piece of information), and recency bias (focusing on recent events rather than long-term trends).
Q5: How does loss aversion impact long-term investment goals? A5: Loss aversion can lead investors to make overly conservative decisions or hold onto losing investments too long, potentially hindering long-term growth and achieving financial goals.
Q6: Can behavioural finance be applied to other areas outside of investing? A6: Yes, behavioural finance principles can be applied to various fields such as marketing, management, policy-making, and personal finance to understand and influence decision-making processes.
Q7: How do behavioural biases affect professional fund managers? A7: Even professional fund managers are not immune to behavioural biases. Recognizing these biases can help them develop strategies to minimize their impact and make more objective investment decisions.
Q8: What is the difference between emotional and cognitive biases in behavioural finance? A8: Emotional biases are driven by feelings and impulses (e.g., fear, greed), while cognitive biases are systematic errors in thinking (e.g., overconfidence, anchoring) that affect decision-making processes.
Q9: How can investors use behavioural finance to gain a competitive edge? A9: Investors can gain a competitive edge by understanding common market biases, avoiding herd behavior, making data-driven decisions, and developing a disciplined investment approach that mitigates emotional influences.
Q10: What are some practical steps to incorporate behavioural finance into an investment strategy? A10: Practical steps include setting clear investment goals, maintaining a diversified portfolio, using checklists to make decisions, regularly reviewing and adjusting strategies, and being aware of and managing emotional reactions.