In a world of numbers, graphs, and economic theory, the notion that our financial decisions are emotionally and cognitively biased may be misplaced. But considering psychology's convergence with the more traditional financial theories, behavioural finance reveals that the decision-making process is far less rational than intuition may foretell. The knowledge of these influences can therefore significantly improve our approach to money, investments, and financial planning.
What is Behavioural Finance?
Behavioural finance not only deals with the impact of psychological factors and cognitive biases on financial decisions, but it is also different from the traditional economic theory that suggests that people make logical and objective decisions since they are self-centered. It is often because of our emotions, social pressure, or mental shortcuts that influence our choices or preferences.
Philosophers and psychologists have long accepted that human behaviour is not always rational. Herbert Simon, rightly titled the father of decision-making theory, coined the term "bounded rationality," suggesting that people simply do not have the time nor mental capacity to sift through all information available, so they use less-than-perfect means to make decisions. This concept served as a starting point in understanding the limitations imposed on financial choices by humans. As Simon once said, "Humans are not rational maximizers; they are satisficers".
Behavioural Finance Simplified
At its core, behavioural finance is the understanding that we don't make entirely logical decisions but that we are greatly influenced by biases. As one might more simply sum it up: behavioural finance is a tool to help us understand why we are making certain financial decisions and make better decisions by being conscious of our emotions and irrationalities.
1. Loss Aversion: This bias indicates that we fear losses more than we enjoy gains. For instance, an investor tends to hold on to a declining stock much longer than he should because he hopes it will bounce back. The emotional pain of a loss makes us unwilling to cut our losses.
2. Overconfidence: Many investors feel they know the markets much better than they actually do. This leads to taking unnecessary risks or ultimately downplaying losses.
3. Herd Mentality: People behave more like a herd, especially when it comes to investment decisions. Investing in whichever stocks are trending or blindly following the latest investment advice can turn out to be horrible choices, made less from any sane financial analysis but due to social pressure.
To make behavioural finance easier, it can be used as a framework for questioning one's decisions. If an individual is feeling the overwhelming urge to fear or get ecstatic about an investment, they should step back and ask themselves if they are making choices under such influence by the biases. That was some time ago when Adam Smith recognized the power of emotions in decision-making, saying, "The greatest improvements in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is anywhere directed or applied, seem to have been the effects of the division of labour." His insights remind us of the need for thoughtful division of our emotional impulses and financial logic.
Applying Behavioural Finance to Everyday Life
Interestingly, one of the best and perhaps most simple behaviours of behavioural finance involves:
1. Automatic Savings and Investments: With the practice of establishing automatic transfers either to a savings account or investment funds, we avoid impulsive decisions based on passing emotions. The automation of such operations reduces the constant emotional evaluation required for financial decisions.
2. Financial Planning: If we set fixed goals and keep to a plan, the emotional decisions on the spur of the moment are prevented. Just as Keynes admitted to the role of "animal spirits" in the economy, we should accept how it is that fear and greed play into our financial decision-making.
3. Destination for Risk Taking: Know your risk acceptance level. What triggers your emotional responses? That will help one not to overcome excessive risks. According to Kahneman, "The way to think about these things is to recognize that emotion is an essential part of decision-making".
4. Learn: So, having a normal grip on biases like overconfidence or loss aversion puts you in a far better place to make more rational decisions related to your money. Educate yourself but then do not make decisions based on temporary feelings or market hysteria.
