Behavioural Finance Overview

Behavioural Finance Definition

• Behavioural finance studies how psychology influences financial decisions and market outcomes.
• Traditional economics assumes rational decision-making, while behavioural finance acknowledges irrationality.
• People often make financial decisions based on emotions rather than logic.

Scope of Behavioural Finance

• Understanding market anomalies: Standard finance often fails to explain market oddities (bubbles, calendar effects, etc.) but behavioural finance provides explanations.
• Identifying investor personalities: Recognising diverse investor types can help develop targeted financial instruments.
• Improving investment advisor skills: Behavioural finance enables advisors to understand and manage investor biases.

History and Objectives of Behavioural Finance

• Behavioural finance emerged from studies like "Psychology of the Stock Market" (1912).
• Daniel Kahneman and Amos Tversky's work in 1979 highlighted the influence of subjective reference points in financial decisions.
• Richard Thaler's concept of "mental accounting" illustrates how people view money differently depending on its purpose.
• Behavioural finance aims to understand investor psychology and use that to refine and improve financial strategy.

Assumptions and Characteristics of Behavioural Finance

• Reflexive decision-making: Fast, intuitive choices based on gut feelings.
• Reflective decision-making: Logical decisions based on careful analysis.
• Loss aversion: The fear of loss is stronger than the desire for gain.
• Bounded rationality: People make decisions with limited information and cognitive constraints.
• Denial of risk: Individuals may disregard statistical odds or obvious risks.
• Framing: How a decision is presented significantly impacts choices.

Cognitive Information Perception

• Information overload: Too many choices can lead to decision fatigue or poor decisions.
• Limited information: People need sufficient experience and effective feedback to make good decisions. This particularly applies to issues like climate change or health.
• Information avoidance: Avoiding potentially negative information can lead to poor decisions, like the "ostrich effect" in investing.

Factors that Affect Investor Psychology

• Stable characteristics: Risk preference, risk tolerance / risk aversion, volatility composure, investor confidence, and investor judgment affect long-term investment decisions.
• Unstable characteristics: Investor perceptions and moods can significantly influence investment decisions, as these are dynamic and often unreliable.

Conclusion

• Behavioural finance challenges the assumption that people make rational financial decisions.
• Behavioural factors profoundly affect investment decisions, impacting their timeliness and outcomes.
• Investments should be made not only rationally but also by taking into consideration human psychology and emotions.