BEHAVIORAL FINANCE: Meaning, Examples & Guide

BEHAVIORAL FINANCE
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You will learn more about behavioral finance in this post, including its biases, examples, and importance. Let’s clarify these two terms, behavioral and finance, before moving on.

Overview

Behavioral, also known as behavior, is an act by which a person, animal, plant, or chemical reacts toward something or people in a particular situation.

Finance, is a fund, money available to a person or organization or a country to run a business, activity, or project. Or the management of the money and the financial economy as a whole in the USA or the world as large.

What Is Behavioral Finance?

Behavioral finance is also known as the psychology of investing. It is the study of psychological effects on investors or individuals and the financial economy or markets as a whole.

Behavioral finance is a study that explains the effects of psychological theories based on investors and their rational decisions, market outcomes, and anomalies. It explains in the real world how financial decisions made by decision-makers might not be rational every time and can cause unpredictable consequences. It also allows the investors to know that they have limits on their emotions, assumptions, and perceptions.

How Behavioral Finance Was Developed

Behavioral finance was derived from the subfield of behavioral economics, which is also a subfield of a traditional economics; that is, the coming together of economics, finance, and psychology to form behavioral economics.

The people who started behavioral finance in the 1980s were Amos Tversky and Daniel Kahneman, who were finance theorists and developed the behavioral finance theory together with Richard Thaler, Hersh Shefrin, Werner De Bondt, Robert J. Shiller, and Dan Ariely. They apply prospect theory to financial markets in different years.

Behavioral Finance Biases

These behavioral finance biases are also examples of behavioral finance. They are the effects that affect the financial economy and individuals psychologically in the way they make their decisions. Knowing the biases of behavioral finance helps us to know how we spend our money and invest, how to overcome them, and how to make better financial decisions. Here is the basic concept of biases below with some other biases.

Read also: Finacial Managements

#1. Loss Aversion

It is a bias whereby investors avoid losses rather than gains. People think and are more sensitive to losing than gaining, and they make decisions concerning the loss, either by forgetting or by making fewer decisions for the gain. This is why some people save rather than invest; they have a fear of taking small risks.

The best way to tackle this bias is to take some risks with assets that typically perform well and create an investment strategy, especially a diversified portfolio of standard stock markets.

#2. Overconfidence Bias

It is when some investors see themselves that they have overconfidence that they overestimate their abilities and knowledge, which can lead to rash and poor decisions.

To tackle this bias is to get an investing pattern, stick to passive investing, no one is above learning, so you can learn from others, and if you are a new investor, consult a good professional. 

#3. Anchoring Bias

This is where investors listen to one decision and value it while ignoring the other decisions. It can influence decision-making and make investors not look into other decisions. It is based on their spending level.

To overcome this bias is to look at decisions very carefully, especially alternative ones. And do research on any decision taken to see if it is a good choice.

#4. Herd Behavioral Bias

With this bias, individuals or investors can’t make decisions or have the fear of making their decisions based on their financial data. As the saying goes, “follow and do what others are doing”. Investors follow their colleagues because it feels safer, but it can backfire and lead to a setback in your investments.

To stop this bias, you need to be able to make rational decisions that will help your financial situation. You can follow other investors if the investment is good, but you should have your own plans behind you in case of any setback.

#5. Mental Accounting

It is a bias that does with individuals or investors have on what they use their money to do. This means the money in their possession has numerous uses, like; fun money, expensive or luxurious things money, if the money is a “gift” to them. But if they earn it, they will save it. It can lead to not completing your budget.

This bias has solutions if you can make a budget of the expenditure and income finances on how you spend and save some of the income for future purposes.

Some Other Behavioral Finance Biases

There are other biases that affect individuals such as:

#1. Emotional bias

Individuals can have this bias due to their emotions. That is, the way they feel and think(fear, anger, being under pressure).

#2. Confirmation Bias 

This is when individuals fail to follow through on their investment or business to see if it was successful. When given information on investment, investors just assume that the information is correct even though is not.

#3. Familiarity Bias

This is when individuals invest in one particular thing or a familiar thing and fail to invest in multiple investments that reduce risks to the investors.

#4. Hindsight Bias

This is when investors have foreseen what will happen with their investment in the future and do not have plans or decisions to make if the investment crashes in the future, thereby leading to hindsight bias.

#5. Illusion of Control

In this bias, individuals or investors think they can manipulate business or investment outcomes, whether they can or not. And more (e.t.c).

Behavioral Finance Examples

  • Limit orders allow investors to have the illusion of control and are also examples of behavioral finance.
  • Some individuals study books that have a meaningful connection between choice and anxiety, which develops the paradox of choice.
  • Having a fear of investing in individuals or investors and relying (overconfidence) on investment and not trying to develop the investment.
  • When individuals fail to have self-control in spending and living to a high standard rather than saving for long-term interest, this leads to self-control bias.
  • Some individuals or investors can take many risks and invest excessively in their accounts. If it crashes, it leads to examples of behavioral finance bias in self-attribution.
  • Examples of bias are when individuals fail to accept their mistakes and make corrections. Rather than finding a solution to the mistake, they plan another one(thinking within). That is the cognitive dissonance bias. etc.  

How to Solve Biases

Here are ways of solving the behavioral finance biases stated above that can tackle or help you with your financial concepts.

#1. Focus on the Process Rather Than the Outcome

When solving a bias, always focus on the process to see if you are doing it right and not focus on the outcome(result) logically.

#2. Prepare Your Decisions and Plan Them

Investors should make or find solutions to their bias by preparing decisions that will help the investor. This will allow you to plan your decisions and pre-commit to see if they are good.

#3. Think Twice

Investors should think very carefully about the decision plan before and after executing the plan to eliminate bias.

#4. Seek Multiple Perspective

You can seek advice and counseling from other individuals, especially professionals, concerning your bias and how to solve it.

#5. Learn to Recognize Mistakes

Some people/investors don’t make corrections to their mistakes, and it is wrong. People should learn and recognize mistakes so as not to make them again and be aware of bias.

#6. Eliminate Emotional Mistakes

When solving bias, some people have a fear of not getting the right solution or taking risks. To overcome a bias, limit your emotions to avoid being in a state of bias in the decision process.

#7. Use Feedback

Solving a bias takes time to process. People can overcome bias if they come across it before or through others with the use of feedback, a checklist, e.t.c. to start the decision process as soon as possible.

Why Is Behavioral Finance Important?

Behavioural Finance is important in that it makes investors or individuals understand what to do with their finances, the decisions they make on how they spend and save their income for future purposes, and helps the economy positively. That is,

  • It allows investors or professionals to know their own biases.
  • It helps investors prepare for their investments and make better financial decisions.
  • It teaches individuals to do research on behavioral bias and helps them plan or make decisions.
  • It promotes financial decisions and can be diverse in one portfolio. 

Conclusion

This article has defined the meaning of behavioral finance and its biases. It also helps individuals think logically and rationally when making decisions about investments or finances. Moreover, its assumption deals with the application of psychology to behavioral finance in the subfield of behavioral economics. It allows individuals to know how to spend and save, and you can seek the advice of a professional for more guidelines.

Behavioral Finance FAQs

What is the role of behavioral finance?

Behavioral finance helps us to know how to make financial decisions in our businesses or investments and guides us through biases.

What is the meaning of behavioral finance?

It is the study of psychological theories derived from behavioral economics based on an individual’s rational decisions, market outcomes, e.t.c.

What are the main concept biases in behavioral finance?

They are mental accounting, loss aversion, overconfidence, anchoring, and herding behavior biases.

What is the foundation of behavioral finance?

It teaches us to know how to save and spend our income. Together with our way of life(emotional, cultural, e.t.c.), with the help of the behavioral finance theorist,

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