Behavioural finance is a branch of behavioural economics, which proposes that various psychological biases influence the behaviour of people towards their financial and investment decisions. People tend to behave differently to even similar news and events, and thus, behavioural investing takes into cognizance the influence of biases in the investment decisions.
Financial markets indeed recognise the fact that investing behaviour is affected by the relative investment biases, instead of staying focused on the rational price movements based on underlying fundamentals. This also forms the premise of the transactions in the equity markets, wherein two people have different investment decisions on the same stock at the same time. While one investor tends to sell the stock at that price, the other investor is willing to buy that stock.
Behavioural Financial Concepts and its Relevance
Behavioural finance generally consists of five main concepts or investing biases:
1.Psychological Investing Accounting:
It refers to making investment decisions based on various psychological motivations and incentives. Financial advisors tend to take benefit of such investment behaviour by linking the financial goals with different investments.
2.Herd Investing:
It refers to the investment decisions made by the investors based on what the herd of investors is doing. Such behaviour explains the fear of missing out syndrome wherein they tend to feel left out if stock rallies.
3.Anchoring Bias:
It refers to the anchoring the investment decisions based on certain levels and information. This assumes importance in the process of budgeting and making investment decisions from such specified amounts. A Systematic Investment Plan (SIP) helps the investors to channelize such budgeted amounts into mutual funds.
The investors tend to stay influenced by the self-induced anchors in terms of his/ her entry price, instead of analyzing the underlying fundamentals or changes in the market conditions. It is often challenging to eliminate such anchoring bias from the investment decisions, as the investors tend to be comfortable with such self-conceived anchors.
4.Self-Attribution Bias:
It explains the investments made by the investors based on his/ her research and knowledge in the subject. An investor is often comfortable in investing in the subject, which is known to them. As such, the investors tend to have a higher level of confidence in such investment decisions, often ranking their knowledge superior to others.
This may lead the investors to invest in the companies they are more familiar with, like domestic companies, companies in which the investor works, etc. For example, an investor who is a doctor by profession may be more comfortable investing in pharma stocks since he/ she is familiar with that sector in a better manner.
Such bias may lead to the absence of diversification in the investment portfolio in terms of different geographies, sectors, etc. Such self-attribution bias also leads to disposition bias, which reflects that the investors tend to book profits on their better-performing stocks while staying invested on to the underperforming stocks and investments. This reveals that the investors are eager to show their winning strategies to others while they are reluctant to admit their investment mistakes.
5.Emotional Bias:
This refers to the decision making based on emotions such as fear of loss, anger, excitement, etc. Further, such decisions may also be influenced due to recency bias. For example, the investors are more likely to stay away from stock, if they have recently lost money investing in such stock. Similarly, if an investor has recently generated healthy profits from stock, he/ she is less likely to admit any adverse changes in the situation in the short term and more likely to stick to stock even in such circumstances.
As such, behavioural finance may lead to several irrational investment decisions as well, which the investors must tend to avoid. Behavioural investing is thus a crucial area to be explored and tamed in the investment journey.