By Seraj Khan, Managing Director of Orient Finance
The broad realm of finance has been often defined by numbers, data and rational calculations. The financial industry is generally considered to be developed upon complex algorithms and economic theories, which have been used to predict, optimise and control outcomes. But it is not all about funds and computations, there is a human factor which is often left overlooked.
The financial sector is significantly influenced by human behaviour. This may sound like a groundless claim, however, in the past few years, several studies have underscored the implication of behavioural finance, as industry professionals strive to perceive the connection between human psychology and investment decisions. The idea behind behavioural finance is to explain how investors make financial decisions and the influence of psychological factors.
The basic foundation of behavioural finance is realising the cognitive biases that impact investment decisions, which often lead to unpredicted consequences. For instance, confirmation biases drive decision-makers to be in a constant pursuit of information that confirms existing beliefs, while overconfidence can lead to excessive trading and overestimation of abilities. Similarly, loss aversion, which is the fear of loss more than the urge to earn a profit, may lead to a more conservative investment strategies.
Another theory which is closely knitted to behavioural finance is prospect theory. The idea contradicts the conventional notion of rational decision-making, which suggests that individuals do not evaluate alternative outcomes in isolation, but rather in terms of perceived benefits and losses in comparison to a reference point. Such methods force investors to avert risks when faced with potential gains and risk-seeking behaviour while confronted with potential loss. In order to make rational investment decisions, it is significant to gain a thorough understanding of the peculiarities of prospect theory.
In addition, behavioural finance explores the concept of framing and perception. These represent the distinctive influence of the information’s presentation on investing decisions, which can lead to varying choices. The framing and perception technique is often exercised by media and news outlets, which can impact investor sentiments. Similarly, cognitive dissonance or the discomfort associated with holding opposing views, can affect investing decisions as people attempt to ease this psychological discomfort.
Investment decisions which are taken under the strong influence of emotions are another factor to be considered. Experts suggest that fear and greed are twin emotions in the financial market that can lead to impulsive and irrational decisions. For instance, if an investor lets their emotions take over their cognitive process while making financial decisions, it may lead to pitfalls of market panics. Understanding the emotional aspects of investing and developing emotional intelligence can help investors make rational choices.
Even though the basic concepts of financial decision-making urge us to adhere to rational paths, sometimes in the face of complex financial decisions individuals often resort to heuristics techniques. While there is a chance that these shortcuts are efficient, they can also lead to faults in judgment. The heuristic mindset pushes us to rely on readily available information, sometimes potentially disregarding significant data. Another issue is that the representativeness heuristic encourages us to base our decisions on stereotypes rather than on unbiased analysis of objectives. We might get fixated on the initial reference points as a result of anchoring and adjustment, which can alter how we perceive value.
Some of the real-world examples of the impact of considering behavioural biases while making financial decisions are the dot-com bubble of the late 1990s and the housing bubble of the mid-2000s. These two stock markets and real estate bubbles vividly depict the influence of investor sentiment and overconfidence. Such irrational exuberance of investors led to the shares exceeding in value as against conventional assessments and finally bursting all financial bubbles.
In order to mitigate such behavioural biases of investors and avert unprecedented downfalls due to it, several technologies and data analysis techniques have been introduced. Solutions like robo-advisers, which rely on algorithms to construct and manage portfolios, reducing emotional decision-making, help investors to make rational decisions. The tools are based on cutting-edge technologies like artificial intelligence and machine learning that can assist in making informed decisions. Furthermore, financial advisors with expertise in behavioural finance can guide investors in better understanding and differentiating emotional and psychological factors that can overturn financial decision-making process. Through such assistance, investors can make rational choices that align with their long-term investment goals.
Evaluating the psychology of consumer investment decisions through the lens of behavioural finance is beyond an academic exercise and it is a practical necessity for anyone navigating the intricacies of the financial world. Recognising such complexities can help to make informed decisions, avoid unprecedented pitfalls and attain long-term investment goals. In the ever-evolving landscape of finance, studies linked to behavioural finance hold significant potential in transforming our investment portfolio and ensuring stability.
