Exploring behavioural finance and understanding its basics

The purpose of any investment is to make a profit and create wealth. While the financial goals may vary – from funding a foreign vacation to building a nest egg – the main motive is to get more returns than those possible with traditional banking products. While some investors may be more willing than others in terms of taking a higher level of risk, one thing is certain – nobody wants to lose money.

However, many investors often react in an irrational, reckless or hasty manner to market changes. But why do investors make such knee-jerk decisions? Behavioural finance gives us the answers.

• Table of contents

1. What is behavioural finance?
2. Fundamentals of behavioural finance
3. What is the importance of behavioural finance?
4. Types of cognitive biases in behavioural finance
5. Behavioural finance: A practical example
6. Behavioural biases in mutual fund investment decisions
7. Managing behavioural biases

What is behavioural finance?

Behavioural finance is a discipline that focuses on finding out how human psychology affects the decision-making process of investors and the financial markets. It explains why investors make decisions based on their biases, emotions, and personal experiences instead of rational decisions backed by data and research.

Fundamentals of behavioural finance

Behavioural finance challenges the notion that investors are rational and markets are efficient by highlighting how emotional and cognitive biases influence investment behaviour. Here are some core elements of investor behavioural, according to behavioural finance.

Key fundamentals of behavioural finance include:

1. Heuristics: Investors use mental shortcuts or rules of thumb to make decisions, often leading to systematic errors or biases.

2. Overconfidence: Investors often overestimate their knowledge and abilities, leading to excessive risk-taking and poor decision-making.

3. Anchoring: People tend to rely too heavily on the first piece of information they receive (the "anchor") when making decision.

4. Prospect theory: This suggests that people value gains and losses differently, leading to risk-averse behaviour with gains and risk-seeking behaviour when it comes to losses.

What is the importance of behavioural finance?

Now that you know the behavioural finance meaning, you may be wondering why you need to understand it. The answer is simple-it can help you make better investment decisions.

Stock markets have been around since the 1600s. People have been investing in stocks for a long time. The process of finding suitable stocks, buying at the right time, and selling at an appropriate time has been refined through the centuries. Presently, there are more tools to analyse stocks and the stock market than ever. And thanks to technological advancements, data is now available at the click of a button and investors can analyse it in minutes if not seconds.

And yet, there is no dearth of investors making irrational decisions.

Clearly, something else is at play here – cognitive bias and limits to arbitrage. These are the two pillars of behavioural finance. Both offer answers to how emotions and biases affect share prices and financial markets. While cognitive bias influences how people behave, limits to arbitrage explain how effective or ineffective arbitrage forces are in different circumstances.

Types of cognitive biases in behavioural finance

Some of the common cognitive biases in behavioural finance are:

Self-attribution bias: When investors believe that a good outcome from their investment comes because of their skilful analysis and any bad outcome is a result of bad luck, it is known as self-attribution bias.

Loss aversion: Many investors lose out on sound investment opportunities when their focus is on trying to avoid a loss. This is known as loss aversion. It is important to note that even the most non-conservative investor can behave this way during their investment journey.

Confirmation bias: When investors believe any information, result or news related to an investment belief they have as a confirmation while ignoring any contradictory information, it is known as confirmation bias.

Herd mentality: If investors start following a trend instead of doing proper research, believing that others may have already done the research – it is known as herd mentality. In such cases, a small event has the potential to disrupt the market and economy.

Disposition bias: Some investors sell well-performing stocks and hold on to ill-performing stocks for a long time believing that the tide will turn. The stock prices continue to fall but they keep holding on to them, thinking that the price will soon increase, and they will make profits. This is known as disposition bias.

Representative bias: Sometimes investors believe that two independently existing things are correlated if they encounter them together on more than one occasion. This linking of two things or events leads to representative bias.

One or more of these cognitive biases come into play when an investor makes investing decisions.

Behavioural finance: A practical example

The global financial markets experienced a significant drop during the COVID-19 pandemic. But even as most stocks plummeted, the pharmaceutical sector remained robust due to the increased demand for healthcare products.

Driven by fear and uncertainty, many investors started herd trading in pharma stocks believing them to be safe bets. Eventually, when the bubble burst and the sectoral stock prices corrected, many investors suffered huge losses.

This shows behavioural biases such as herding can lead to irrational investment decisions with investors ignoring fundamental analysis and chasing a prevalent trend. Understanding these behavioural tendencies can help investors make more rational decisions.

Behavioural biases in mutual fund investment decisions

Mutual funds are a popular investment avenue for many reasons. However, while mutual funds offer the promise of diversification and professional management, the investors’ decisions to buy, hold, or sell the funds are often swayed by psychological biases.
Let’s take a closer look at some of the common behavioural biases at play:

• Loss aversion: This bias refers to the human tendency to fear losses more than enjoy gains. Due to this, investors might hold onto underperforming mutual fund schemes longer than necessary, hoping to break even. The psychological pain of realising a loss often outweighs the logical decision to sell and potentially reinvest elsewhere. This may result in holding onto a declining fund for longer than necessary, waiting for it to rebound, thereby missing out on other potentially lucrative investment opportunities.

• Mental accounting: Investors often treat money differently based on its source or intended use – an error known as mental accounting. Mental accounting can be particularly tricky with mutual funds. For instance, gains from a mutual fund might be viewed as "free money" and spent unwisely, whereas the principal investment is treated with more caution. This kind of mental separation can lead to inconsistent investment decisions where certain portions of the investment are not optimised for the ideal return potential.

• Recency bias: Mutual fund investors often fall for recency bias, where recent events or trends unduly influence decisions. If a particular sector or type of fund has performed well recently, they might assume it will continue to do so and invest more heavily in it. Conversely, if a fund has underperformed in the recent past, they might avoid it, even if its long-term prospects are solid.

• Confirmation bias: Once an investor has chosen a mutual fund, there is a tendency to seek out information that validates that choice and ignore data that contradicts it. This can lead to an overconfidence in the fund's potential and a reluctance to reconsider the investment, even when signs suggest it might be time to re-evaluate.

• Herd mentality: This bias manifests when investors follow what everyone else is doing, rather than basing decisions on independent research or their risk profile. If there's a buzz around a particular mutual fund and many are investing in it, others might jump on the bandwagon, fearing that they are missing out. Conversely, if many are selling a particular fund, it might trigger a panic sell-off, even if the fund's fundamentals remain strong.

By understanding these behavioural biases and their nuances, mutual fund investors can be more vigilant and make decisions that align with their investment goals and risk tolerance. Awareness, education, and sometimes even a contrarian mindset, are crucial to understand the world of mutual fund investing.

Managing behavioural biases

Awareness is the first step towards overcoming biases. Recognising the behavioural biases of individuals allows one to guard against them or sometimes even employ them advantageously. Here are some ways to effectively manage behavioural biases:

• Recognise, reflect and correct: One of the first steps to combat behavioural biases is self-awareness. By identifying which biases are most likely to impact them, investors can begin to notice patterns in their decision-making and take corrective actions. Knowing one’s behavioural biases can also work to an investor’s advantage. For instance, if an investor recognises their tendency towards loss aversion, they can set stricter rules about when to sell a mutual fund, ensuring they stick to a rational decision-making process.

• Diversify investments: Diversification can act as a safeguard against the fallout from some behavioural biases. If loss aversion makes an investor reluctant to sell a declining mutual fund scheme, a diversified portfolio can help mitigate the impact of potential losses.

• Consult with professionals: Financial advisors and mutual fund managers are not immune to behavioural biases, but their professional training often equips them to manage these biases more effectively. Engaging with professionals can provide an objective perspective, helping to counteract personal biases.

Conclusion

In conclusion, behavioural finance explains how human psychology works and affects the world of finance. It tells us that instead of thinking logically and rationally, investors let past experiences, personal preferences and beliefs cloud their judgement when they make investing decisions. By understanding and addressing these psychological factors, investors can potentially improve their financial outcomes. Moreover, tools like a compound calculator and mutual fund lumpsum calculator can assist investors in visualizing the potential growth of their investments through the power of compounding. This can help them stay calm in the face of temporary volatility and stay invested to potentially meet their financial objectives. For example, using an SIP return calculator can help investors estimate the future value of their investments, providing clarity and aiding in better decision-making.

FAQs:

What is behavioural finance?

Behavioural finance is a field that combines psychology and finance to understand how emotions and cognitive biases influence financial decision-making. It delves into why investors often deviate from rational choices and how these deviations impact markets and investment outcomes

How do emotions affect investment decisions?

Emotions like fear and greed can lead to impulsive investment choices. Investors may panic during market downturns or chase hot trends, often resulting in suboptimal returns.

What are common behavioural biases?

Common biases include overconfidence, loss aversion, and herd mentality. Overconfidence leads to excessive trading, while loss aversion causes investors to avoid losses at the expense of potential gains. Herd mentality makes individuals follow the crowd, often causing bubbles and crashes.

Can behavioural finance improve investment success?

Yes, understanding behavioural finance can help investors make more rational choices. Recognising biases and emotions allows for better decision-making and long-term financial success.

What are the two pillars of behavioural finance?

The two pillars of behavioural finance are cognitive biases and limits to arbitrage. Cognitive biases look at how emotions and decision-making patterns can lead to irrational financial behaviour. Limits to arbitrage looks at the constraints that prevent rational traders from correcting market inefficiencies caused by irrational investors.

How does behavioural finance differ from traditional finance theories?

Traditional finance assumes that investors are rational and markets are efficient. In contrast, behavioural finance recognises that investors are driven by emotional and psychological forces, which can lead to irrational financial decisions. Fear, overconfidence, loss aversion, mental short-cuts and other cognitive forces shape investors’ decisions, leading to anomalies and inefficiencies.

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