At its core, behavioral finance attempts to understand biases in human behavior when it comes to personal finance. It combines social and psychological theory with financial theory as a means of understanding how price movements in the securities markets arises independent of any corporate actions (changes in the intrinsic value of the stock). One of the biggest challenges to investors’ own success can be their own instinctive behavioral biases.
Traits of behavioral finance are:
- Investors are treated as “common” not “rational”
- They actually have limits to their self-control.
- Investors are influenced by their own behavior patterns.
- Investors make cognitive errors (influenced by psychological factors) that can lead to wrong decisions.
|Anchoring||Fixing on rules of thumb or references mainly based on your past experience.||“I lost all my money in the 2008 financial crisis. I am certain I cannot make money in the stock market anymore”|
|Recency||The tendency to think that what’s been happening lately will keep happening||During the bear markets, people tend to forget about the out performance in the bull markets.|
|Familiarity||Investors tend to only invest in products they are familiar with or investment vehicles that are always in the limelight.||Investors tend to get comfortable with age old products and forget that “familiar” doesn’t always means “safer” or “better.”|
|Herd Mentality||People get influenced by peers and replicate what others are doing.||“Everyone is doing it. I should too.”|
The role of behavioral finance is to help investors understand price movements in the absence of any intrinsic changes on the part of companies or sectors or the economy as a whole. It highlights the impact of an individual behavior on his financial decision making abilities. But how should one tackle these biases in order to maintain a systematic plan to achieve the goals? A brief period of mindfulness will help tackle psychological biases. Relying on reflexive decision-making (going with your gut) makes us more prone to deceptive decisions. Establishing logical and methodological decision-making processes can help protect from such errors. It is important to be focused on the process rather than the outcome.