Why Should an Investor be Careful About Behavioral Finance?


Though it seems both the market and investors are following only the footsteps of economic analysis and market fundamentals but it is always not the case scenario. More often an investor gives more priority to his thoughts than mathematics calculation and reality; and takes irrational decisions. In one word, it is Behavioral Finance.

Here are many investors who are reading this word for the first time. ‘Behavioral Finance.’ So, for all of them, it is better to start from the beginning.

What is ‘ Behavioral Finance’ all about?

It is nothing but a pure explanation. The behavioral finance will explain to you about the psychological effect that can be usually seen on the behavior of investors. The focus point of the behavioral finance study is why the investors are not always rational and why they are influenced by their thoughts. 

But behavioral finance theory does not rule the roost alone. The theory is opposed by traditional finance theory as well.

Now, we should take a look at how the traditional finance theory is explaining the mental behavior of the investors, and how the behavioral finance theory is opposing it.

Traditional financial theory on market and investors:

·        Both the market and investors act rationally.

·         Investors have total self-control over them.

·        They are not confused and are free form any kind of error.

In opposed to it the behavioral finance have its theory as well:

·        Investors should be treated as normal persons. So, every decision taken by them cannot be considered as purely rational. Investors are sometimes confined to their own biases. 

·         As described in the traditional finance theory, the behavioral finance theory says investors do not have total control over themselves. It means they lack self-control. 

·        Sometimes, the investors make errors too. They make wrong decisions after becoming confused.

Why should you be careful about behavioral finance?

If an investor is aware of beforehand about the psychological effects of behavioral finance, then he/she can make a difference between facts and irrational things attached to behavioral finance.

The example of how behavioral finance works

·       High-thinking about oneself:

This high-thinking about oneself is an actual example of behavioral finance. Sometimes, the investors become the victim of overconfidence and buy out shares which have no actual value in the market.

If we explain it then the result says you are thinking yourself smarter and a person of more capability, is the source of behavioral finance.  As it is said earlier, the traditional finance theory will say that though a particular stock has given the investors good results beforehand and it has reached its top-level capability now. An investor will not get much profit if they invest in it now.

But the behavioral finance theory will ignore the rational part and will look at the stock as his/her trusted aide. So, the investor will again invest in the share, and chances are either the investor will suffer a loss or he/she will only gain profit after a longer time than expected.

·       Going for herding-investment:

Like overconfidence, usually, people suffer from herding-investment too. Herding-investment means you are following the same way that the majority of people are following.

Like, you can say following a stock market expert; the majority of share market investors rush to buy that particular share. They are not even bothered by the other stock market experts’ view on the stock. The stock market investors do not even check the graph, the history of the stock by themselves.

All are caught by the buying mania then and the investors only show hurriedness to buy the stock. Perhaps, the share won’t get that much profit as it is said. You are clearly a victim of herding-investment.

·       The Anchoring Bias:

Usually, experts say it is a classic example of behavioral finance. The anchoring bias reflects that you are too rigid for the stock market. Here rigidity refers to that you rely too heavily on the information that you have seen first.

For example, you have seen a stock price that falls in the low range. Neither you think twice nor see any graph or chart or hear what the financial experts are giving feedback on that particular share. You just only see the share price is too low and simply buy it.

This is explained as the anchoring bias. Here your rigidity is only showcased and nothing else. The anchoring bias is not at all good for the share market investors. 

·       Mental accounting:

In behavioral finance, mental accounting is considered as the fourth barrier for the stock market. You have decided that you will buy shares from the auto-sector. You start gathering money with the aim of the auto-sector.

Even if the share of the auto-sector falls suddenly, and the share of other sectors like IT rises quickly, despite all the negative news you will remain firm to your decision about buying shares from the auto-sector.

You may suffer a loss in investment due to your behavior. This adamant nature of mental accounting is included in the behavioral finance category.

How can you overcome the behavioral finance problem?

Though some behavioral finance barriers come in the way of investing, there are some strategies too that you can use against the problem of behavioral finance.

·       Rely more on the reflective decision making rather than on the reflexive one:

First, get an understanding of the difference between reflective decision-making and reflexive decision-making.

Reflective decision-making:

You are going through logical and methodical ways and taking all your financial decisions. It means you are able to make reflective decisions.

Reflexive decision-making:

You are believing more in your instincts. Reflexive decisions usually come automatically in your mind.

If you take every decision in a reflexive way then you are an emotion-driven person. Financial experts say taking reflexive or emotionally-driven decisions is not good for the investment market.

You should try on how to take the majority of your investment market decision through a reflective way or through a logical and calculated way.

·       Give all your focus on prepare and planning:

As we have discussed earlier, the reflexive decision is not suitable for investment. You have to make logical and mathematical decisions, so, if you make preparation and planning from beforehand then chances are you will get a good return from your investment.

Usually, all the financial experts say if you follow these two techniques then you can guard your money against behavioral finance.

Apart from investment where do we observe our tendency to go towards behavioral finance?

We generally observe our tendency to go for behavioral finance when we need some money on an urgent basis. We lean towards a payday lender when we suffer from instant cash-crisis. The payday lender gives us a loan very quickly in 1 or 2 days and that too without any formality.

It is another classic example of behavioral finance. We then take the loan in urgency but later repay the debt with a minimum 300% interest rate. 

If you have become entangled in such a situation of behavioral finance and do not know how to settle your payday loans then taking assistance from a loan-expert will be the logical and rational way for you.  

“There’s a big difference between a long-focused value investor and a good short-seller. The difference is psychological and falls into the realm of behavioral finance.”  

  – James Chanos

What else?

We all know it very well that success cannot be achieved overnight. If you are following your instincts and think behavioral finance will help you win then you are making a mistake, my dear friend! You need planning, scheduling, and goal-setting to achieve success in the investment market. The role of behavioral finance is very limited here.