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:

An individual who is capable of identifying the flaws in his behavior is capable of optimizing his decision and is wise enough to learn from his mistakes.
Anomalies are extremely important part of active management.
Individuals, who believe in the fact that markets are rational and the prices are inclusive of all type of information available, are capable of relying on passive management.

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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 deals with the Emotions.
Cortex deals with Logic
Recumbent Part deals with body functions.

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:

Loss prevention.
Pursuit of reward

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.

Confirmation Bias:

People happen to be more inclined towards whatever information they have in their mind. Their existing beliefs have a huge impact on what decisions they make for their investments. Any information that passes by them, that supports their belief, immediately grab their attention. At times, they do not even confirm from other sources, if their beliefs are valid or are based on some ground realities.
Mental Accounting:

People tend to view their hard earned money different from their inheriting money. Sometimes, the company that has previously earned them a lot of profit has a special corner in their heart. They won't stop investing in it, even if it's going in loss. The need of staying loyal, influences the decision making ability for lot of investors. Similarly, if they inherit Stocks from their forefathers, they prefer to hold down to them, even if they are of no good now.
Illusion of Control:

Most of the investors make their decision under the illusion of control. For example, if a person went with his own theory and invested his money in some stocks that later brought him lot of profit, will continue to believe that his theory is all that he need in the stock market. The idea of having control over making decisions without taking help from any external information, leads to failure at times. There is no theory that proves that if a person was right at one thing, will be right in everything else as well.
Hindsight Bias:

People usually like to make predictions. If one of their predictions comes true, they will stick to making more. However, behavioural investing is much more than wealth management. The stock market is one of the most uncertain markets in the world. No one can ever be sure what is going to happen next. Making decision purely on the basis of prediction is the key to bad decision-making skills.
How to be a better investor:

Behavior oriented investments are a common thing and every once in a while everyone comes under its influence. However, the key to success is to outsmart yourself and make better decisions that are free from any type of biasness of emotions.
Eliminate emotions:

One of the biggest hurdles on the way to rational decision making is the involvement of emotions. To be a better investor, keep your emotions aside while you are making any investment. Do not let the sense of loyalty or inheritance come in the way of your decision. Your decision should be based on the basis of statistics.
Do your Research:

To make a rational decision free of emotions and beliefs, one needs to get his hands on as much as information he can get. The key to find right and authentic information is by doing behavioral finance research. While you are thinking to invest your money in any company, do your own research to have little peak in the outcome of decision that you are making.
Narrow down your options:

Seeing too many options can make an ordinary investor confused, but what a wise investor can do is narrow down his options. On the basis of your research, narrow down the options that are available in front of you. Once you are done with that part, it will be a lot easier for you to make your final decision.
Step out from the World of illusion:

No one knows everything and nobody has control over everything. To be a better investor, you need to learn these two facts. If you choose to remain under the illusion of knowing everything, you will never be able to explore more and more about the stock market.
Prepare yourself for all types of outcomes:

When an investor only plans for the success and forgets about the loss, this is when he steps out from the zone of the rational thinking. A good investor should prepare himself for the good as well as bad outcomes, no matter what.
Go Old School:

Ever heard the term "Don't put all your eggs in one basket"? Well, this term completely fits the complex nature of the stock market. Being one of the most uncertain markets, it is never a wise thing to invest everything at one place. You might end up with do or die situation. To be a better investor, diversify your investment in different places. The chances of getting maximum profit are usually high going this way.

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