11 Most Important Concepts of Behavioral Finance Theory

Behavioral finance is a famous field of finance that suggests theories based on human psychology (financial psychology or behavioural economics) in order to explain the concept of stock market anomalies, which includes extreme rise and fall in the prices of stocks.

Behavioral finance suggests that the structure of the information and characteristics of participants of the market plays an important role in decision making of the investors as we as the overall outcome of the market.

Behavioral Finance and Investors:

Behavioral finance is more inclined towards the investors and their decision making for the following reasons:

Psychology and Finance or The Brain And You!

The brain and its composition have been through a lot of evolution till date. The current composition is originated from the old times of the Stone Age when the basic needs were to hunt for survival. The needs of that time were different from the modern age. The current composition and its structure are not fit for modern age.

According to the Cerebral research, there are three centers inside the brain. All these centers are developed and interacted in a very different way.

Limbic System

Limbic is responsible for all types of emotions including excitement as well as fear. The limbic happens to be the oldest part. The emotions were part of the life before logic came in. This part of the brain works very quickly.

Cortex

Cortex is basically responsible for all the learning, conceptualizing, logical thinking, calculating and making financial planning. Cortex works slowly and takes time to make an investment decision.

These two parts of the brain plays a very important role in decision making. Both of these work in very different way, but these function together.

Cortex and Limbic, together form two types of systems. The behavioral patterns are basically controlled by these two systems:

According to an old and exaggerated term used in stock market: The entire market moves between the fear and the greed which are two extreme ends of loss prevention and pursuit of reward.

Psychology and Economics

In order to make best financial decisions,which is free from any type of emotions for financial investments, one need to stay rational. There is an economist deep inside each and every individual.

The economist in you,makes you earn your bread and butter by working. However, no one is born with super powers, of remembering all type of information, and making decisions free of emotions.

The main problem with individuals and their decision making skills is that they have the urge to carry their entire history of development with them.

This information about development was helpful long ago, but today in this modern world, that type of information is no good. Today, it's important to combine the behavioural dynamics of the old times with the logical thinking.

Behavioral Finance has been able to derive the behavioral dynamics that can be combined with the logical thinking. Today, an individual who knows and understands these behavioral science is capable of knowing his abilities and improving them.

What is 'Behavioral Economics'?

Behavioral Economics is the study of psychology and finance, as it relates to the decision-making process behind an economic outcome of individuals and institutions.

Nobel Prize in economics has already been awarded to a number of behavioral finance theorists that includes Daniel Kahneman, Richard Thaler and few more.

Observations on Behavioral Economics:

Behavioral Finance has been part of some major research labs and since then there has been a lot of observations made.

The Fear of Loss vs. Excitement to Gain:

The main reason investors put their hard earned money into something is to get profit out of it. However, they are well aware of the fact that profit is not the only thing they should expect.

With every investment, the chances of meeting loss are equal as of the profit, but these two probabilities do not leave same impact on the investors.

According to common observation, the fear of losing their money is lot bigger than the excitement to gain something.

Moreover, it is hard for them to accept that they have made a bad investing decision. They cling to their decision and hope to get their money at the end of the day.

In such cases, the investors usually end up losing everything for once and for all.

Believing Whatever They Want To:

The investors have a great tendency to completely ignore all the bad investment news around them. Instead they believe in whatever they want to believe, even if it means that putting their investments at stake.

They sometimes use completely baseless information to support what they believe in. On the other hand, a successful investor does an in-depth analysis of financial markets before investing in anything.

Impact of Detailed Information:

Investors are more inclined towards the term "Quantity over Quality". Reading precise but intact information do not leave a lot of impact on them.

They instead feel more motivated on reading detailed information. The length of the reports plays an important role on their decision making process.

Confusion in Making Investment Decision:

One of the main thing that confuse investors to make a final decision, is the presence of lot of choices. When an investor has a lot to choose from, his mind starts second guessing.

Options that have identical products or similar prices tend to confuse investors. In such scenario, instead of making a rational choice, they randomly choose one option that can turn out to be unexpected one in the future.

Flow:

The investors have a great tendency of going with the flow.

There are times when they, on purpose go with the flow, thinking that since the majority of the people are inclined to it, it might be the right choice.

This specific point of view of the investors can later lead them to big loss.

Behavioral Biases:

For the investors, the entire decision making process is a war between the brain and emotions. There is a huge percentage of biasness involved in a decision made by most of the investors.