Putting money into things like real estate or gold requires both bravery and a willingness to accept risks. The average person is unaware that traditional and behavioral finance both play a part in deciding whether or not an investor would choose to purchase shares of a certain firm; yet, both factors do play a role.
Under the assumptions of standard financial models, both the investor and the market behave rationally. Everything that they know comes either from personal experience or from the experiences of others, and all of their conclusions are based on evidence that can be verified. Therefore, according to the principles of traditional financial theory, investors should avoid allowing their emotions to play a role in their choices about their investments.
The effect of human psychology on economic behaviour is the subject of investigation in the academic discipline known as “behavioral finance.” In accordance with the tenets of the field of behavioral finance, the decisions that investors make on how they allocate their capital are influenced, at least in part, by their feelings and the ideas they bring to the table. Fear, overconfidence, following the gang (also known as “herd behaviour“), gut feelings, what others do, and previous experiences are all things that might impact an investor’s decision making regarding behavioural finance.
Distinction Between Traditional and Behavioral Finance
The study of psychology is very important to the discipline of behavioural finance since it helps to understand why and how people make specific decisions about their finances. According to behavioural finance, which is founded on real-world experiences, people’s decisions about their financial investments are influenced more by their feelings than by their logic.
Emotional factors include things like a person’s history of trust in a firm through time, familiarity with its brand and products, heuristics, and recommendations from friends and family.
For example, a significant number of athletes have established brand loyalty to Nike due to having great interactions with the firm in the past. These sportsmen have a high degree of trust in Nike and are acquainted with the products offered by the brand as a result of their long-term relationship with the company as clients.
This demonstrates the impact of confirmation bias since the athletes’ everlasting confidence in the brand leads them to make buying choices based only on their feelings.
Several biases in behavioural finance might lead customers to make bad decisions. The great majority of us, including the vast majority of people in the world, are not immune to these prejudices, and neither are human beings.
In this section, we will investigate the five types of bias that are most prevalent in the field of behavioural finance.
The process of seeing monetary transactions in a way that is different from their source is referred to as “mental accounting,” and the word itself refers to this practise.
The “mental accounts” that we establish for our money eventually shape the purchase decisions that we make, thus the term “mental accounting.” It’s conceivable that this is too much information at first, but the following example might help explain things.
Loss aversion refers to the natural tendency of humans to avoid losing money or other valuables, even if doing so requires them to pass up other opportunities.
As a side point (and as a nice reminder), the concept being addressed is communicated by the name itself. Because “aversion” means “dislike,” “loss aversion” refers to the mental state in which a individual is willing to do whatever in order to avoid experiencing a loss.
You’ve undoubtedly heard that those who take risks earn the most money, yet the fear of losing money prevents us from attempting new things, even if those things could turn out to be profitable.
The propensity to have an inflated opinion of one’s own abilities is what’s meant when people talk about “overconfidence bias.”
Because behavioural finance places such heavy focus on the psychological aspects of decision-making, investors may erroneously believe they have a high degree of knowledge and, as a result, make decisions that are not in their best interests.
Because of a cognitive bias known as “anchoring,” we tend to put an excessive amount of importance on the very first piece of information we are presented with. That is to say, we have a propensity to put the highest importance on the information that we learn initially.
When people make decisions based on what the group as a whole seems to be doing, this is an example of a bias known as herd behaviour.
When this happens, investors often prioritise the general public’s views above the empirical data provided by the economy.
The next logical question to ask is, “Why?” This happens because going along with what the majority of people do seems to be the most prudent choice. The “fear of missing out” is another factor that leads investors to conform to the mindset of the herd.
However, investors who operate within the more traditional field of finance are noted for their pragmatism and the fact that they base their decisions on empirical information obtained from things such as mathematical calculations, economic models, and the activity of the market.
That is to say, both buyers and sellers are able to take in facts without bias and make decisions that are well-informed.
Classical economics suffers from several problems, many of which can be traced back to the unrealistic assumptions that people are endowed with infinite knowledge and that heuristics are devoid of relevance.
This “error” occurs when a person places excessive reliance on their own discretion. Another potential objection is an overconfidence in the reliability of statistical evidence, which implies that the numbers might be wrong.
The conventional view of finance assumes that traders and investors have flawless knowledge and are constantly up to speed on the most recent developments.
This is an incorrect assumption because it is not feasible for us to know all there is to know about the financial markets and other things linked to them. If this were the case, everyone would have flawless judgement and the ability to make decisions that are beneficial to their financial situation.
As was said earlier, information is not always accurate; as a result, it is not always a good idea to base one’s decisions only on statistics. In addition, there is a possibility that it is not always sensible to base one’s choices on statistics.
In classical finance, in addition to the assumption that market participants possess all of the relevant information, it is also taken for granted that investors and savers do thorough market research before acting.
If the price difference between eBay and Amazon was just one dollar, for instance, a customer who was acting absolutely rationally would choose to purchase shoes from eBay rather than Amazon.
When it comes to issues with money, it is impossible to deny the influence that one’s own feelings have on one’s judgement, in contrast to the logical reasoning that is supposed in traditional financial theory.
It is not true that investors are greedy or narcissistic just because they look out for themselves and act in their own self-interest. This term gives the impression that investors are wary of taking risks and are eager to get every possible benefit.
However, contrary to what is expected in traditional approaches to finance, not everyone acts in their own best interests.
The stock market is the primary contributor to the significant gap between traditional and behavioural finance. Making the assumption that the stock markets are stable paves the way for us to get to the heart of the matter.
Any rational person who invests in stocks should examine the trends of the market by utilising moving averages and other indicators. This is a fundamental principle of traditional economics and financial theory.
However, it is common knowledge that the stock market is very volatile, which makes it difficult to have enough information. This is where the field of behavioural finance comes into play.
In this sense, customers may only be able to depend on their instincts or the guidance of those who are most familiar with them.
The individual and macroeconomic results of behavioural finance and traditional finance are quite different from one another. In addition, their spectrum of effects is vast, spanning the positive to the bad in equal measure.
We know now that speculation is crucial to the smooth operation of the stock market. Because of this assumption, there is opportunity for the growth of new firms and the creation of viable alternatives for investing surplus reserves, which enables the stock market to perform its function as an allocator.
In the same vein, unfettered speculation that’s based on rumours has the potential to do more damage than good. For instance, it might lead to the formation of asset bubbles, the collapse of which could start off another economic downturn on par with that of the Great Recession of 2008.
Conventional and behavioral financial theories attempt to explain financial markets and economies, but they do so from different vantage points. The three most important differences are listed down below for your convenience.
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