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Behavioural finance combines psychology and economics to explain how cognitive biases and human emotions drive real-world financial decisions. Aspects such as overconfidence and fear of missing out often decide what you buy and when you sell. This, in turn, affects the market and its outcomes.
This article takes a detailed look at behavioural finance and its core concepts, the specific biases behind it, and how it compares with traditional finance.
Key Takeaways
- The behaviour of investors is totally unpredictable and can change in a short span of time.
- Investors often buy stock due to emotional reasons and hold on to it despite losses.
- Behavioural finance is driven by factors such as loss aversion and herd mentality.
- Investors attribute any profit to their skill and losses to bad luck.
- People are more likely to focus on information about an investment that confirms their pre-existing beliefs rather than focus on new information which contradicts their views.
What is Behavioural Finance?
Behavioural finance is the study of how psychological influences and cognitive biases affect the financial decisions of investors. This, in turn, affects market outcomes such as bubbles and crashes. It grew out of work by psychologists Daniel Kahneman and Amos Tversky as they challenged in the 1980s the assumption that people evaluate risk rationally.
Where traditional finance assumes investors are rational actors, behavioural finance treats investors as "normal." It essentially positions them as people who are influenced by emotion, mental shortcuts, and social pressure.
Concepts in Behavioural Finance That Influence Investors
Behavioural finance revolves around psychological factors that influence decision-making. It reveals why investors may take decisions that are not based on data and facts.
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Loss aversion
People fear losses more than they appreciate gains. If someone gains ₹1,000 and loses ₹1,000 on consecutive days, they would be more upset about the loss than they are content with the gain. This is why many people hold onto falling stocks hoping simply to “get back to even.”
This is what loss aversion is about. Kahneman and Tversky’s experiments showed that people tend to avoid losses much more strongly than chase equivalent gains. When faced with a sure gain versus a risky bigger gain, people often play it safely. But when the same choice is framed as a loss, they become much more willing to take the gamble. This happens just to avoid accepting the loss.
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Herd mentality
Retail investors often rush into stocks heavily bought by high-profile figures or trending on social media, blindly if institutional or well-known investors have already completed all necessary due diligence.
Examples:
- Bombay Oxygen stock price movement during Covid-19
- During the second wave of COVID-19 in April 2021, there was a shortage of oxygen in some hospitals in India.
- A company called Bombay Oxygen rose from ₹10,000 to ₹23,000 in a span of two weeks.
- The interesting part was that Bombay Oxygen is not related to producing or transporting oxygen at all. It is an investment company.
- Just because of “Oxygen” in the name, it rose more than 100% in the two weeks.
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Overconfidence bias
Investors may overestimate their knowledge and decision-making skills, leading to losses. They may feel that a bad investment can recoup losses easily and continue to put money in loss-making ventures.
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Mental accounting
It is the tendency for people to treat money differently based on its source or intended purpose, rather than viewing all capital as completely interchangeable (fungible).
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Confirmation bias
Investors naturally seek out and favour information that supports their existing views while actively ignoring or dismissing red flags and contradictory research.
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Self-attribution bias
Investors may give credit for any profit to themselves. Losses are seen as an outcome of bad luck.
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Recency bias
More value may be given to recent market trends than historical performance of a firm or company fundamentals.
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Anchoring bias
Investors may fixate on a specific point or number, such as a share price, and make decisions accordingly. This can impact their ability to judge data and reorient investments in case of losses.
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Disposition Effect
This is the tendency to sell winning investments too early to lock in a gain while holding losing investments far too long in the hope of breaking even. Studies and expert analysis have shown that investors realise gains noticeably more readily than losses. The winners that they sell outperform the losers they keep holding, a pattern that directly erodes long-term returns.
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Availability Bias
People overweight information that is easy to recall, typically because it was recent or heavily covered in the media. This is contrary to their attitude towards information that is statistically representative.
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Regret Aversion
This is the fear of a future decision turning out to be wrong, which can cause two opposite but equally costly reactions. It can prompt investors into freezing into inaction (staying out of the market) or following the crowd into a popular trade simply to share the blame if it goes wrong. This can lead to herd behaviour in markets.
Why is Behavioural Finance Important for Investors?
Behavioural finance highlights what factors may lead to a stock price falling or rising suddenly. It gives weightage to psychological decisions by investors and explains how they can drive market sentiment.
- May help in capitalising movements: Behavioural finance can help people capitalise on short-term market movements that are driven by impulses, such as a stock rally driven by positive investor sentiment as seen in the dot-com bubble. However, it can also lead to big losses as relevant data is ignored or not given enough importance in favor of biases and emotions.
- Understand your patterns: For you as an investor, understanding behavioural finance can help you recognise your own patterns before they become expensive habits.
- It cannot, however, predict the exact timing or magnitude of the next bubble or crash, and only explains the psychological mechanics behind these events.
|
Aspect |
Traditional Finance |
Behavioural Finance |
|
View of investors |
Rational, processes all available information correctly |
Influenced by emotion, bias, and social pressure |
|
Explanation for bubbles/crashes |
Attributed to genuine new information reaching the market |
Attributed to herding, overconfidence, and overreaction |
|
Practical implication |
Favours low-cost, passive, index-based investing |
Favours awareness of one's own biases and a disciplined process to counter them |
How to Limit the Impact of Behavioural Biases?
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Automate the decision: SIPs make this easier because the investment happens automatically.
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Set your rules beforehand: Decide things like your stop-loss or profit target before you are emotionally attached to the investment.
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Diversify: Do not put everything into one stock or sector just because you are confident about it.
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Review on a schedule: Checking your portfolio every day can make small price movements feel like a big deal. Instead, check it at set intervals to avoid any panic-driven decision.
Conclusion
Behavioural finance reveals that stock markets are driven by human psychology just as much as spreadsheets and balance sheets. Cognitive traps like loss aversion, overconfidence, confirmation bias, and herd mentality frequently push investors toward impulsive decisions and unnecessary losses.
You cannot eliminate market volatility or control how other investors act, but a documented plan, automated investing and periodic, fundamentals-based review meaningfully reduce how much your own biases cost you.
