What is Behavioral Finance and how does it affect your Financial decisions?
Created on 14 Sep 2020
Wraps up in 4 Min
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Updated on 26 Aug 2023
After reading this blog's title, you might feel that "behaviour" and "finance" are two different things. How can they be interlinked in the same phrase?
Behaviour is all about emotions, personalities, psychology, and sociology. And finance is all about numbers, equations, statistics, and balance sheets. Right? Don't worry; we will explore this in detail together in this one and our upcoming blogs.
The most common assumption of standard finance is that human beings are "rational." This means that humans analyze the pros and cons of any situation and then choose the one which is best for them. But the critical question is, are we rational? And if we really are rational, then why do we throw lavish birthday parties or luxury wedding receptions because these decisions are certainly not rational.
In the past few years, a lot of people have started practicing investment. While most of these investment decisions are based on research and logic, some decisions are a result of your mood or instinct, and chances are, there may not be any logic behind that.
Do you know what this is called? Or why people make these types of decisions? Behavioural Finance goes further and explains this.
What is Behavioral Finance?
In simple terms, Behavioral Finance is:
Psychology + Finance
The behavioral economic theory states that:
Markets are inefficient.
Humans are irrational.
In the last example, we talked about some irrational actions that humans do, like organizing a birthday party. Well, you might be asking a question to yourself, why do we make these irrational decisions? Well, these decisions are the functions of your heart.
Behavioral finance helps us understand that our mind is one part, and our heart is another part of making choices or decisions.
The origin of behavioral finance can be traced back to the 1990s, and Daniel Kahneman, along with Amos Tversky, gave the essential theories of behavioral finance. They also got the Nobel prize for the same in the year 2002.
These theories will be briefly discussed in the upcoming blogs. The two pillars of behavioral finance are cognitive psychology (how people think) and the limits to arbitrage (when markets will be inefficient).
Traditional Finance vs Behavioral Finance:
There are various criteria on which we can identify the difference between standard finance theories and behavioral finance theories.
One such aspect is Risk; the standard finance theory considers risk as an objective term that risk can be quantified. Risk can be calculated as beta, or risk can be calculated from the standard deviation.
But behavioral finance theories say that risk is subjective. One person can have a different level of risk-taking capacity than another person, and it cannot be objectively measured. Also, there are differences in the two theories concerning the Return.
Standard finance assumes that risk and return has a linear relationship; that is, if risk increases, the return will also increase but behavioral finance says that there is an inverse relationship between perceived risk and perceived return. Here we are not talking about actual risk and actual return, because it is a personal risk. So the risk is perceived, and return is also perceived return.
Based on the behavior, standard finance theories say that the decision-maker is rational. In contrast, the behavioral finance theory states that human beings are irrational, and he would take all the decisions based on irrationality.
Based on the consistency of decisions, Standard finance assumes the decisions to be consistent; that is, the decision maker's behavior is also constant. That is 2+2=4 (Always).
But Behavioral finance argues that the decision will be inconsistent because several factors are affecting that decision. For example, that particular human being's personality or the attitude of that person towards certain things will affect his decision.
What is the need of behavioral Finance and it's importance:
Do you remember the Dot Bubble that happened in the year 2000 or the global financial crisis in 2007?
Well, we were all affected by that. But traditional finance models failed to predict the market. It was identified by various economists and the governments of several different countries that we lack behind on something. Later it was found that behavioral finance gives all the answers related to these mishappenings.
Robert Shiller, who won the Nobel Prize in 2003, stated that the stock prices could be predicted over a more extended period, such as over several years, and he concluded that markets are inefficient.
He also predicted an IT Bubble that's going to crash in his book 'Irrational Exuberance 2000' and later in his revised edition, which was published in 2005, he talked about the Real Estate bubble that was about to crash in 2007, and his predictions were accurate. He used behavioral finance theories to prove all that.
Hopefully, by now, it should be clear how crucial behavioral finance theories are and how useful its implications can be.
Summing it all up
You might have heard a common phrase that "Even smart people make Big Money mistakes." Well, this is true Because IQ has nothing to do with money mistakes. It's the heart and emotions that are essential, explained in different behavioral finance theories.
Behavioral finance suggests that the structure of information and characteristics of participants of the market can play an essential role in the decision making of the investor as well as the overall outcome of the market.
Behavioural Finance is about making the right decisions that are free from any kind of biases and errors. It helps in understanding investor behavior better and helps in improving the financial capability of individuals.
People can earn better returns if they know what the biases which are affecting their decision making are, and thus they can make better decisions.
It is also helpful in designing wealth management strategies. It is beneficial for portfolio managers, mutual fund companies, investment consultants, and all those who are guiding people on how to invest their money.
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