Behavioural Finance: Uncovering the Human Factors in Financial Decision-Making

Posted on Dec 09, 2023 at 11:12 PM

Behavioural finance is a subfield of behavioural economics concerned with investment money and finance. This term appeared several years after psychologists and sociologists opposed the popular theories of economics and finance under the pretext of the following two reasons:

1. The stock exchange could be more efficient in the real world. 2. People often need to be more rational when making purchases.

So, the science of economics emerged, with its many branches, to address these behavioural issues, including Behavioural finance, which is the subject of our discussion in our article for today. 

What is Behavioural Finance?

Behavioural finance includes reading and analysing the psychological influences and biases on the financial behaviours of investors, business owners, or traders within the commercial and financial markets. In addition to its effect on ordinary people! Moreover, it can explain all types of market anomalies, such as severe rises or falls in a company's stock prices.

Behavioural finance is about the study and understanding of inefficiencies and mispricings in financial markets. It uses experiments and research to prove that humans and financial markets are only sometimes rational and that their decisions are often flawed. 

So, innovative financing can help make better, more rational, and modern decisions.

Behavioural finance gives you the answers you wonder about the impact of biases and emotions on the money market, stock prices, and more. For more information about the financial field, you can invest in accounting training courses in Dubai.

These intensive courses provide real-world knowledge and experience to help companies understand the influences and biases of behavioural finance.

Behavioural finance originated from the group work between Jewish psychologists Daniel Kahneman and Amos Tversky and American economist Robert J. Shiller in the 1970s-1980s. They applied pervasive, deep-seated, subconscious biases and heuristics to how people make financial decisions.  

At about the same time, the efficient market hypothesis (EMH) emerged, a popular theory that the stock market moves in rational, predictable ways and doesn't always hold up under scrutiny.

In the past decade, behavioural finance has been embraced in the academic and financial communities as a subfield of behavioural economics influenced by economic psychology. So financial automation can help you save time and money and make rational and informed financial decisions.

What are the Key Concepts in Behavioural Finance?

Five key concepts are commonly used in behavioural finance, including:

1. Mental Accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes and goals.

2. Herd Behavior: Herd behaviour states that people tend to mimic the financial behaviours of most of the herd. This is the reason behind the stock market's massive rally and sell-off

3. Emotional Gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Often, emotions are a crucial reason why people do not make rational choices.

4. Anchoring: Anchoring refers to attaching a spending level to a specific reference. Examples may include spending consistently based on a budget level.

5. Self-attribution: Self-attribution refers to the tendency to make one's own decisions based on overconfidence or one's skills.

What are the Most Common Biases in the World of Behavioral Finance?

Behavioural finance biases are a vital component of the financial decision-making process of domestic and international corporations and institutions. Let's look into a brief description of a few common biases in the world of behavioural finance:

• Confirmation bias: 

Confirmation bias occurs when the investors align with the information that matches their beliefs. The data could be wrong, but they rely on it as long as it fits with their views. 

• Experimental bias: 

It occurs based on an individual's past experiences. Investors' memories and experiences in similar situations play a crucial role in managing their decision, even if it is irrational. They study the effects of their previous positions on their business and, based on that, choose the most appropriate theories to invest in the company.

• Loss aversion: 

Loss aversion makes investors avoid any decision with a percentage of risk, even if it earns high returns. They give priority to restraining from experiencing losses rather than experiencing high returns.

• Overconfidence: 

Overconfidence is a double-edged sword. That is, an exaggerated belief in abilities and skills and a lack of concern for the opinions of the surrounding team affect the ability of investors to make imaginary decisions not based on any factual evidence.

• Disposition bias: 

In this type, investors cling to their wrong decisions, believing it is just a matter of time before the tides change for them. For example, investors may hold on to a stock whose value is declining daily because they believe that the price will rise again, and they will sell it at a high price and make record profits. This way of thinking creates many business risks.

• Familiarity bias: 

This bias addresses why investors place all their investments in an industry they know rather than trying other areas with higher profit opportunities.

• Mental accounting: 

This rational bias is aimed at how people think about spending and budgeting with the variables in their lives. For example, people may spend a lot of money on luxury in a shopping mall or entertainment trip, but they also possess a modest lifestyle at home.

In Conclusion,

Having introduced you to the essential concepts and biases in behavioural finance, we can only say that humans and stock exchanges are not always rational and that their decisions are often flawed. Nevertheless, behavioural finance can help us understand why people and financial analysts make sudden, irrational decisions based on emotion and feeling, which are often incorrect and cause losses.