A Guide To Behavioral Finance

By Author: finology ventures
Total Articles: 13
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Behavioral finance talks about the change in behavior of investors because of psychological influence. In short, it comprises economics and psychology.
Behavioral finance theory: The behavioural finance theory says that
Markets are ineffective.
Individuals are illogical.
Investors get affected by their own biases.
Investors often tend to make errors which leads them to make wrong decisions in investment.

CONCEPTS OF BEHAVIORAL FINANCE : behavioral concepts comprises of five concepts they are as follows:
Mental accounting: It means allocating money by investors for a particular purpose.
Herd behavior: It states that people often tend to imitate the financial behaviors of the bulk of the herd. Herding is famous in the stock market as the cause behind exciting demonstrations and sell-offs.
Emotional gap: It refers to decision making based on emotional pressures such as stress, fear or over confidence. Most of the time, emotions are the main reason why an individual does not make rational choices.
Anchoring: it refers to adding upon a spending level to a certain backing. ...
... Examples may include spending consistently based on a budget level or thinking to spend based on different satisfaction advantages.
Self -attribution: self- attribution refers to propensity to make decisions based on confidence in one’s own skill set and knowledge. Self attribution usually arises from the natural confidence of a particular state. Within this classification, individuals tend to rank their skills, experience, knowledge greater than others.

Note: Before getting into biases, lets first dig into investment, for investing stocks firstly you must have a demat account. In order to Find the best stock brokerbest stock broker, Visit the site select by finology.

WHY INVESTORS ARE NOT ALWAYS RATIONAL?
While investing, our decisions are often determined by intuition. We usually choose the most effortless option available to us. We just go by gut instinct or by emotion, we tend to take more risks when we are happy and become bearish when you are depressed or by social influence, it depends on whom you met and what that person told you. All these result in incorrect decision making. To invest efficiently you need a process that you follow every time vigorously.
Don’t just think about profits always but also plan for losses.

BEHAVIORAL FINANCE: BIASES AND THEIR IMPACT: Investment decisions are largely influenced by their personal biases. Let’s look at six examples of behavioral finance biases which influences or effects the decision making of an investor that are easy to explain and understand by everyone:

Loss Aversion: Everyone loves to make more and more profits and avoid losses that makes us unhappy. It is important to diversify and have some guard in place to prevent losses. Also, we have a diminishing sensitivity to losses. When your position turns negative, you may look at the market every 5 to 10 mins. However, when the losses increase we need to stop looking at the app altogether.
Investors usually don’t look at the overall portfolio but an individual investor’s and how each one of them is performing.

Decide a strategy before investing and then by monitoring it continuously.
Overconfidence: Overconfidence means believing you are better then you actually are.
Things that cause over confidence in financial markets are:

1.Self- attribution : when you have profits, you feel it's because of your own skills. In short, you think Everyone is stupid except for me. When you have losses, you find it easy to blame others and external factors which are not predictable.

2.Hindsight : hindsight means believing that you already know how things are going to turn out . In this case, you forget the things that you are wrong about or you remember them incorrectly.In short, people with hindsight mindset always feel “I told you so”.

3.Anchoring bias: we always select those which support our opinion and ignore the rest. According to this bias, we tend to collect information that supports our decisions or ideas about an investment rather than collecting information in the first place that contradicts our ideas.

4. Trend- chasing bias: here investors predict future investments performance by taking its past performance into consideration. This illusion of predicting future performance by past performance usually fails because owners of investment try to advertise more when their investment is past performance is good to attract new investors which further may not give beneficial results in the future for investors.

5. Familiarity bias: Usually investors like to invest in those investments which yield them more returns and less risk. Before investing they compare the past performance over the years which are successful and well known investments. This bias should be removed because unknown investments may also give more returns. an investor should keep in mind that familiar investment cannot give you consistent profits. it’s the potential investments projects which yields more returns in the near future.

6. Herd mentality bias: here an investor without making an in-depth analysis of an investment, just by hearing others opinions he invests in it. Most of the time this mentality leads an investor in incurring losses.

HOW TO OVERCOME BEHAVIORAL FINANCE BIASES:
Behavioral biases are often considered as barriers to investment success. Even logical people often tend to give emotional reactions to new information which leads to poor investment decisions. Investors who try to avoid behavioral biases have more chance in getting success in investments.

MANAGE EMOTIONS: Research studies show that investors feel more pain when they get loss when compared to happiness they get from profits. Investors need to manage emotions like the first thing an investor should understand is that an investment is a combination of both risk and return. An investor should not become overwhelmed when he is getting profits[returns] or he should not get depressed when he is getting losses.

BE A RENTER NOT AN OWNER : Firstly, investors should not develop personal attachment to the investment. All the successful investors tend to maintain emotional distance with their stock and they consider their stocks as rentals so that they can be rational and also can make effective decisions at the time of selling or retaining their investments. So, investors should not get affected by the result in investment and should consider them as rentals.

STOP CHASING TRENDS: usually people have a tendency to invest in those stocks which are giving more profits thinking that it gives similar returns in future. But the main important thing an investor should remember is markets are uncertain and even a continuous profit giving investment cannot give you profits in the future.

PAY MORE ATTENTION TO DETAILED ANALYSIS: Before making any investment, an investor should make deep analysis wholly like a company’s performance over the years, who are its stakeholders, debt, profits etc. rather than just depending on the information provided by the company one should make deep analysis in order to avoid losses in the substantial future.

SEEK CONTRADICTORY OPINIONS: A Successful investor often considers contrary opinions provided by others before making a decision. They decide strengths of competing arguments and then finally make a decision regarding investment.

CONCLUSION:
So, this is how behavioral finance impacts an investor. Before making any investment decision, an investor should not be biased and also should make in-depth analysis to get more returns. Biases can be controlled in order to be a successful investor.