Behavioural finance is defined as deviant habits that can affect financial decision-making. What are examples of Behavioral Finance?

What Is Behavioral Finance?

The following are definitions of Behavioral Finance.

Adam Hayes, Investopedia (2022) Behavioural finance, a subfield of behavioural economics, proposes that psychological influences and biases affect the financial behaviours of investors and financial practitioners.

Kaplan Financial Education (2021) Behavioural finance studies the effects of psychology on investors and financial markets.

Corporate Financial Institute (2022) Behavioural finance is the study of the influence of psychology on the behaviour of investors or financial analysts.

As investors, our decisions are often emotional and not objective.

One example is buying stocks, which are being talked about a lot by influencers. Many people call this discriminatory behaviour FOMO or fear of missing out.

In addition to FOMO, there are other distorted behaviours, biases, and emotional influences in financial decision-making.

The History of Behavioral Finance Research

Behavioural finance was first researched by two psychologists, Daniel Kahneman and Amos Tversky, and an economist, Robert J. Shiller, in the 1970s-1980s.

They applied pervasive subconscious biases and heuristics that affect how people make financial decisions. At about the same time, many economic researchers proposed the Efficient Market Hypothesis – EMH theory.

EMH claims that a stock market moves rationally predictable way and doesn't always stay under scrutiny. Due to investors' wrong thinking about price and risk, the market needs to be more efficient.

Why is it Important to Understand Behavioral Finance?

When aware of deviant behaviours, you can make more objective decisions and get more optimal results.

10 Financial Biases

Behavioural finance tries to understand the impact of bias on investors. Here is a list of the various biased behaviours:

Overconfidence and Illusion of Control

Overconfidence can lead to wrong and misleading judgments.

Many novice investors seem confident in their skills, intelligence, and talents. The fact is that these skills, intelligence, and talents have yet to be tested over a sufficient period.

Self Attribution Bias

Self Attribution Bias is the tendency of investors to attribute good results due to their hard work and bad effects due to conditions (e.g., being unlucky).

Most people want to get credit for their hard work (including investors).

Therefore, many investors feel proud when the results of their analysis are correct, and they make a profit. On the other hand, they want to avoid being blamed when their analysis results are inaccurate and suffer losses.

Hindsight Bias

Beginner investors often feel they "KNOW EVERYTHING" and are "RIGHT" about the conditions that occur. Usually, if someone already feels they know everything, they will be arrogant, and their investment decisions will not be objective.

Confirmation Bias

Beginner investors often look for information that is ACCORDING to their analysis and AVOID information that does not match.

Example: An investor buys technology stocks. They will choose news stories that support the positive movement of technology stocks and avoid bad news that claims otherwise.

The Narrative Fallacy

When the investment decisions are based on a story but not on facts or objective data.

Example: An investor initially did not want to buy ABCD stock because the company was losing money and had never made a profit.

But a news story claims that ABCD company will develop new technology that can make the company profitable. Suddenly individual investors start buying ABCD company stock.

Representative Bias

The similarity of objects or situations causes investors to need clarification when making decisions.

Example: Many people suddenly panic and hold cash just because they feel that interest rates are rising and there are many unemployed people (without first consulting more detailed macro data).

Framing Bias

The bias occurs because of the way information or data is presented.

Example: Earnings per share in the third quarter amounted to IDR 100, higher than the second quarter with an EPS of IDR 80, even though the income in the third quarter came from the sale of assets, not from business operations.

Anchoring Bias

The bias occurs because investor makes comparisons to past prices without considering the conditions that are presently happening at this time.

Example: ABCD company shares are currently IDR 1,000 per share. Whereas in the past, ABCD shares were valued at IDR 5,000 per share. ABCD company's sales continued declining due to intense industry competition.

Loss Aversion

Many investors want to avoid admitting they were wrong in their analysis and realize their losses.

Example An investor speculates that a share's fair price is IDR 1,000 per share. ABCD's share price has decreased to IDR 500 per share.

This investor will want to refrain from re-checking their calculations and assumptions in valuing the share. Therefore, the investor is "stuck" with ABCD shares.

Herd Mentality

Influencers or stock groups influence many novice investors. They buy or sell a stock because of recommendations from other people.

How to Not Be Biased?

One way to avoid bias and remain objective is to have a clear investment plan. You can also benefit from having a wealth advisor to help the investment process stay objective.

Moduit Beyond is a Wealth Management service offered in partnership with experienced financial advisors.

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Sources: Kaplan Financial Education . 23 Juli 2021. What is Behavioral Finance?. KaplanFinancial.com Adam Hayes. 13 December 2022. Behavioural Finance: Biases, Emotions and Financial Behavior. Investopedia.com CFI Team. 29 November 2022. Behavioral Finance. CorporateFinanceInsititute.com