Behavioural Finance- How to improve the way you invest and how?

Economic, financial analysis and fundamentals are important but, its not that the investors and markets move solely on these. Investors also appear to lack self-control and decisions are made based upon personal biases rather than depending upon the facts.

These are part of the investors psychological influences and is called “Behavioural Finance”

There are few questions that will force us to think about this, such as-

• Why are we inclined to sell the shares in our portfolio that perform well and hold onto those that perform poorly? Or,

• Why should we always buy auto insurance and never electronics insurance?

• Why should we always buy auto insurance and never electronics insurance?

There are many similar questions that we have in our minds and behavioural finance can help address and provide insight into these questions.

WHAT IS BEHAVIOURAL FINANCE?

We can say that the irrational behaviour of the investors and the markets as well have brought the Behavioural finance in a rational way. It is a sub field of behavioural economics that proposes that psychological influences and biases affect the financial behaviours of investors and financial practitioners.

If we think then the traditional financial theory has a rational hold on the markets as well as the investors, as they are not confused with the cognitive or the informational processing errors.

Behavioural Finance involves identifying and categorizing common behavioural patterns that defy the ‘rational’ model of consumer choice, in other words, it assumes that we are not rational decision makers.

This field of study takes into consideration human behaviour that is often assumed to influence market outcomes and returns, one of its key aspects is biases. Biases can usually be classified into five key concepts namely:-

1. Confirmation bias

2. Experimental bias

3. Familiarity bias

4. Loss aversion,

5. Disposition bias.

The understanding and usage of behavioural finance bias is applied to stocks and other trading market movements daily. These trends can be used to help analyse market price levels and the fluctuations for speculation as well as decision making purposes.

There are four concepts of behavioural finance that are considered to be the main key concepts-

• Herd Behaviour -The habit of people to imitate the financial behaviour of a majority.

• Mental accounting -The propensity to allocate money for specific purposes.

• High self-rating -The tendency of individuals to rank themselves higher than an average individual.

• Anchoring -The attachment of a spending level to an easy reference, like spending more money for a popular brand of anything.

SO, WHY IS IT IMPORTANT?

The prevalence of behavioural finance in our society, and If you notice carefully, you will see the investors use a approach of “consensus” wherein they all combine their expectations and act in unison.

On the other hand, there are investors who are likely to trade on stocks that are expected to beat the consensus and avoid those stocks whose market value is considerably less than the fundamental value as per the consensus. Therefore, the concept of behaviour is applicable from the moment investors attempt to spot the future behaviour of fellow investors.

So, what can be said is that people are not always rational just like the market is not always efficient. Behavioural finance helps us understand why people usually do not make decisions that they are supposed to, just like why the market acts unreliably at times.

Research indicates that many investors make decisions not based on logic but emotion which is usually seen in cases where the investors purchase stocks at higher price based on speculation and then sell off at lower price under panic.

So, behavioural finance helps us in avoiding the decisions driven by emotion that ultimately leads to losses. While it is difficult to prove that it contributes in improving the performance, but it is easy to understand that there are certain biases that influence our investment decisions. And it is impossible to eradicate them altogether, you should take steps to recognize your biases and safeguard yourselves from its shortcomings.