Behavioral finance is a relatively modern area that blends psychology and financial theory. It attempts to explain why individuals make irrational financial decisions.
Behavioral Bias
Behavioral bias refers to the social, cognitive, and emotional factors that influence an individual’s decision-making process. People are often overly optimistic about their ability to invest, so they assume that they can beat the market or identify firms that are undervalued. Such behavior leads to overconfidence, which results in poor decision-making and ultimately leads to underperformance.
Herd Mentality
Herd mentality is another concept in behavioral finance. It occurs when several investors buy or sell assets based on the actions of others instead of making calculated decisions based on research and analysis. Herd behavior often results in asset bubbles, where assets are valued significantly higher than their fundamental worth.
Loss Aversion
Loss aversion is a phenomenon that occurs when individuals are more sensitive to potential losses than gains. Hence, they would rather avoid losses than seize opportunities for gains. This mindset leads to irrational behavior where investors hold onto failing investments, hoping they will return to their former glory instead of cutting their losses and moving on.
Confirmation Bias
Confirmation bias occurs when investors seek out and remember information that confirms their existing beliefs, and selectively ignore information that contradicts their views. Investors tend to read and remember news that supports their investment decisions and ignore stories that challenge their views. This behavior creates an overreliance on personal beliefs, creating a distorted view of the market.
Conclusion
Behavioral finance is an emerging area of study that helps us understand irrational financial decision-making. Investors must recognize their behavioral biases and work to mitigate them to improve their financial decision-making process.
