Have you ever fallen for a clever marketing scheme at the grocery store and realised your mistake days later? Have you ever paid an enormously large price for a pair of shoes that all your friends own? Have you ever signed up for an expensive fitness programme and failed to follow it? Classical economic models assume that we consumers are fully rational in our decision-making processes. These models posit that we rapidly assess the satisfaction we will get out of a product, efficiently compare different alternatives, and act solely to further our self-interest. However, the last few decades have marked the advent of a new school of thought: one that rejects the idea of absolute consumer rationality.
Behavioral economics, this new line of thinking, proposes that consumers do not always act in rational ways; therefore, classical economic theories do not always apply to today’s markets. The concept of behavioral finance was born out of this change in thinking, and while the fundamental ideas governing the two domains remain the same, their scope and applicability differ. Traditional financial theories proposed that, apart from the assertions in classical economic theory, financial participants have perfect self-control and are only interested in utilitarian characteristics. However, behavioral finance accounts for irrationality and fills the gaps in these theories. It considers how psychological biases and influences affect the behaviour of investors and financial practitioners.
Behavioral finance studies the psychological influences on a financial stakeholder and how these influences affect market outcomes. Some of the key concepts and biases that punctuate this domain are the herd mentality, disposition bias, loss aversion and familiarity bias. Herd mentality, for instance, is the tendency of stakeholders to follow the financial behaviour of the majority; infamous periods of volatility in the stock market are often attributed to this bias. Loss aversion is another inherent human bias that states that the human fear of financial losses often outweighs the pleasure from financial gains. These are only a few examples of the several biases and influences that behavioral finance explains; they are immensely useful in furthering our understanding of finance right from the decision-making of one investor to the fall in the value of an entire asset class.
Understanding the nature of these influences have significant effects on one’s perception of financial markets and the behaviour that follows. By being aware of the previously mentioned disposition bias - the tendency of investors to rapidly sell their winners and keep holding onto their losers - we can be more thorough thinkers about our investment positions and increase our gains or hedge our losses. Reflecting on our familiarity biases - the tendency of investors to invest in only what they know and are comfortable with - could open up more financial options and provide better returns. Finally, understanding the experiential bias, one that posits that financial predictions are largely based on past experience, can allow us to be more conscious of our thinking process and avoid a rigid approach to a financial decision. It is not difficult to appreciate the fact that a fundamental understanding of lessons in behavioral finance will almost always lead us on a path of greater wealth and prosperity.
The last question we must consider is: how exactly do we process and apply the learnings of behavioral finance? It is hardly as complicated as it may initially seem. The first lesson we must learn is that human decision making is done in two broad ways: reflexively and reflectively. Reflexive decisions are ones that are made automatically, without much thought. For example, the decision to pay using a credit card. Reflective decisions are more thoughtful and time-intensive decisions (like the decision to buy a new car). Any financial participant must think deeply about which of their reflexive decisions are costing them time and money, and thus he or she must make amends and avoid the unconscious losses they so regularly incur. Second, we must understand that the root of financial disappointment and the most important gap between old and new theories is the lack of human planning and self-control in our financial decisions. Preparing, planning and pre-committing is an undisputed key to success and most of our cognitive biases can be overcome if we are more disciplined in the aforementioned processes. The greed of an investor that is on a winning streak is a key reason for his or her downfall; a plan and pre-commitment to the plan is the only way such a downfall can be prevented. Warren Buffett says “Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” By carefully considering the decisions we make and by being disciplined financial participants, we undoubtedly have the power to negate the biases and influences on us and move in the path of greater prosperity.