Behavioural Finance: Uncovering the Psychology Behind Financial Decision-Making

Behavioural Finance: Uncovering the Psychology Behind Financial Decision-Making

Have you ever wondered how some people are able to make the right decisions and become filthy rich whilst others just can’t seem to make up their minds? How do some people manage to stay wealthy whilst others remain living paycheck to paycheck?

This idea comes from behavioural economics, the study of psychology that deals with these kinds of financial behavioural patterns. Behavioural finance is a sub-group of behavioural economics that provides a detailed view of behavioural patterns in various areas of financial management.

Robert Kiyosaki’s book, Rich Dad Poor Dad, can be an example of behavioural finance. The author deftly covers the internal biases children inherit from rich or poor parents that ultimately influence their financial decisions.

Introduction to Behavioural Finance

Behavioural finance can be useful in business when it comes to making crucial financial decisions. Understanding the factors that drive financial decision-making is vital for success. 

What is the Difference Between Traditional Finance and Behavioural Finance?

Whilst traditional finance theories often assume that investors make rational choices based on all available information, behavioural finance sheds light on the psychological biases and influences that shape financial decision-making. It offers valuable insights into why people make impulsive and irrational financial decisions.

This study of behavioural finance is beneficial for formulating financial systems better suited for people as it considers behavioural patterns and spending practices when creating financial management systems. Think of it as a shoe that is tailor-made just for you!

Understanding Investor Behaviour and Decision-Making

Behavioural finance offers decision-makers a personalised financial system that would consider their financial nature and spending habits. While it is an efficient tool for psychological analysis, behavioural finance also contributes significantly to businesses by helping them understand their investors.

Investor behaviour plays a pivotal role in financial decision-making. This branch of behavioural finance explores how individual investors process information, assess risk, and make choices. 

How does Behavioural Finance Help Understand Investor Behaviour?

Behavioural finance delves into the cognitive and emotional factors that influence financial decision-making processes. Some examples of influences include risk aversion, perception of market trends, and emotional biases.

Finance executives can better assist their clients in aligning their investment strategies with their goals, by understanding their financial behaviour. 

Studies have shown that individual investors tend to exhibit herding behaviour, follow the crowd without thorough analysis, and tend to buy high and sell low. Understanding these patterns can help guide investors toward more informed decision-making.

The different types of psychological influences seen in investor behaviour are listed below.

  1. Cognitive biases in financial decision-making

Cognitive biases are innate human tendencies that can distort logical judgment and decision-making. In the world of finance, these biases can significantly impact investment choices. One of the chief applications of behavioural finance is research on cognitive biases.

This study has identified various cognitive biases that affect financial decision-making:

Confirmation bias: This bias is quite prevalent among investors. Confirmation bias leads them to favour information that supports their existing beliefs while turning a blind eye to contradictory evidence. This bias can cause investors to overlook crucial data and make unfavourable investment decisions. 

Availability heuristic: This bias causes people to choose to focus on highly publicised and readily available information rather than choosing to research the matter thoroughly for themselves. This can result in investors making decisions based on recent events or media coverage, rather than considering the long-term consequences of an investment.

  1.  Emotional influences on financial choices

Emotions play a significant role in financial decision-making. When people face financial choices emotions, such as fear, greed, and excitement, can cloud clear judgment. 

For example, the fear of missing out (FOMO) can cause you to make impulsive investment decisions. On the other hand, greed can drive you to take excessive risks in pursuit of higher returns. A great example of this would be gambling, poker, and even excessive investment in the stock market.

Understanding the emotional influences on financial choices can help investors recognise and manage their emotions effectively. Employing a more rational approach and considering long-term goals can help investors avoid making decisions based on fleeting emotions.

  1. Prospect theory and loss aversion in behavioural finance

Prospect theory was developed by Daniel Kahneman, a Nobel memorial prize Economist and Amos Tversky. In this theory, they explain how individuals make choices under the influence of uncertainty.

This theory says that people tend to process financial decisions around their dread of potential losses more than their potential gains. 

This phenomenon, known as loss aversion, can significantly influence investment and basic financial decisions.

How loss aversion affects investor behaviour

Loss aversion leads individuals to be more risk-averse when faced with potential losses. They may prefer to avoid losses even if the potential gains outweigh the risks. Understanding this bias can help investors design a financial portfolio that considers their loss aversion.

  1.  Anchoring and mental accounting in financial decisions

Anchoring refers to the tendency to rely heavily on the first piece of information encountered when making decisions.

In the context of financial decision-making, people may seal their expectations or valuations to their initial reference points such as the asset purchase price or the previous market price. 

This anchoring bias can prevent investors from adjusting their valuations based on new information, leading to potential mispricing and missed opportunities.

On the other hand, mental accounting refers to the practice of categorising money into different mental accounts based on its source or purpose. 

This bias can lead to ill-suited financial decisions as people may fail to consider the overall portfolio. It can also lead to errors as individuals under this bias fail to make rational decisions based on data when allocating funds across different accounts.

  1.  Overconfidence and its effects on investment strategies

Overconfidence is a psychological bias in which individuals overestimate their abilities, knowledge, and decision-making skills. The cause for this bias could be familial upbringing, financial disposition, seniority in knowledge or even an inflated ego.

In finance, overconfidence can lead investors to take excessive risks or trade frequently based on unrealistic beliefs in their ability to outperform the market.

Understanding the effects of overconfidence on investment strategies is essential for financial professionals. By promoting self-awareness and encouraging realistic expectations, professionals can help investors avoid the pitfalls associated with overconfidence and develop more prudent investment approaches.

Applications of behavioural finance in investment management

Behavioural finance findings have significant applications in investment management. For example, as a financial professional, you can utilise these insights to understand your investor’s needs, risk tolerance, and decision-making biases. 

By incorporating behavioural finance principles into investment strategies, you can design more tailored offerings that align with investor preferences and goals. You can also use it to enhance risk management practices.

By considering the biases and emotional factors that influence investment decisions, you can develop strategies to combat potential negative outcomes associated with irrational investor behaviour. 

Behavioural finance uncovers an intersection of psychology and financial decision-making. By understanding the psychology behind financial decision-making, you can navigate the market better and help your clients achieve their long-term financial goals.

If you are a student or professional looking to upskill your knowledge in finance, look no further than the London School of Business and Finance, Singapore (LSBF SG). 

Rated among the top 10 institutions for accounting and finance in Singapore, LSBF SG has numerous world-class accounting and finance programmes that you should consider.

Sign up today to upgrade your skills and start your success journey!

This article was written by Rebecca Paulraj and edited by Candice McDowell

References:

  1. https://investopedia.com/terms/b/behavioralfinance.aspa
  2. https://www.sciencedirect.com/science/article/pii/S1364661316300997
  3. https://www.sciencedirect.com/science/article/pii/S1364661316300997
  4. https://www.toptal.com/finance/financial-analysts/investor-psychology-behavioral-biases
  5. https://www.figmarketing.com/blog/the-psychology-of-financial-decision-making-understanding-behavioral-biases-and-improving-client-outcomes/

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