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 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 Management
#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 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, and 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 setbacks.
#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 learn about it through others, with the use of feedback, a checklist, etc., to start the decision-making process as soon as possible.
What Does Behavioral Finance Tell Us?
Understanding how human emotions, cognitive biases, and cognitive limitations of the mind in processing and responding to information can have a significant impact on financial decisions such as investments, payments, risk, and personal debt is one of the main contributions that behavioral finance makes to our knowledge base.
What Is the Behavioral Finance Concept?
The meaning of term “behavioral finance” refers to the phenomenon of an organization making irrational financial decisions by drawing a connection between such decisions and the psychology of humans. The research provides evidence that various psychological influences and biases have an impact on the financial decisions made by market participants and, as a result, the outcomes of the market. Having an understanding of this psychological influence can help one comprehend the various behaviors of the market and make better decisions regarding investments.
What Is an Example of a Finding in Behavioral Finance?
It has been discovered that investors consistently keep holding on to investments that are performing poorly for a significantly longer period of time than what rational expectations would indicate, and they also sell winning stocks too soon. This phenomenon is referred to as the disposition effect, and it represents an application of the principle of loss aversion to the field of investing. Investors who are already losing money on their investments may even increase their wagers and take on further risks with the aim of turning things around.
What Are the Two Pillars of Behavioral Finance?
Cognitive psychology and the concept of limits to arbitrage make up the two foundations. The field of cognitive psychology seeks to understand how the subjective thinking of individuals might affect their ability to make reasonable decisions. The boundaries of arbitrage make it possible to distinguish between situations in which the arbitrage forces will be effective and those in which they will not be successful.
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, etc.
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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