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Behavioral Finance & Its Elements

BEHAVIORAL FINANCE Introducation:

Behavioral finance is a new paradigm in the finance theory, which aims to comprehend and anticipate the psychological decision making of individual investors and systematic implications of such decisions on the financial market (Olsen, 1998). Behavioral finance does not attempt to substitute but to complement the existing theories of finance and investment. Here, the present assignment deals with the psychological investment decisions and financial planning of individual.

Peter Bernstein (1998) in his book Against the Gods has stated that repeated patterns of illogicality, inconsistency, and ineffectiveness can be observed in the decision or choice making of human beings in the context of uncertainty. Conventional financial writing theory assumes that most of the investors are rational wealth maximizers, still numerous instances are observed in the real world where the emotion and psychology of individual influence the decisions to behave in erratic or irrational ways. Through behavioral finance theories, behavioral and cognitive psychological theory is attempted to be combined with the conventional economics and finance. This novel field is able to explain why individual makes irrational financial decisions (DeBondt, et al., 2010). 

There is not any single popular theory of behavioral finance. Different authors have different opinions. Traditional paradigms for investment decisions, according to Benartzi and Thaler (2001), are under diversified, loss averse (Odean, 1998), as well as overconfident (Odean, 1999). Barber and Odean (2000) argue that individuals tend hold on the loser stocks too long and sell the winner ones premature. On contrary to this, Grinblatt and Keloharju (2000), traders are much reluctant to realize losses and generally trade without rational motives.

Behavioral finance is a new paradigm in the finance theory, which aims to comprehend and anticipate the psychological decision making of individual investors and systematic implications of such decisions on the financial market (Olsen, 1998). Behavioral finance does not attempt to substitute but to complement the existing theories of finance and investment. Here, the present assignment deals with the psychological investment decisions and financial planning of individual.

Peter Bernstein (1998) in his book Against the Gods has stated that repeated patterns of illogicality, inconsistency, and ineffectiveness can be observed in the decision or choice making of human beings in the context of uncertainty. Conventional financial theory assumes that most of the investors are rational wealth maximizers, still numerous instances are observed in the real world where the emotion and psychology of individual influence the decisions to behave in erratic or irrational ways. Through behavioral finance theories, behavioral and cognitive psychological theory is attempted to be combined with the conventional economics and finance. This novel field is able to explain why individual makes irrational financial decisions (DeBondt, et al., 2010). 

There is not any single popular theory of behavioral finance. Different authors have different opinions. Traditional paradigms for investment decisions, according to Benartzi and Thaler (2001), are under diversified, loss averse (Odean, 1998), as well as overconfident (Odean, 1999). Barber and Odean (2000) argue that individuals tend hold on the loser stocks too long and sell the winner ones premature. On contrary to this, Grinblatt and Keloharju (2000), traders are much reluctant to realize losses and generally trade without rational motives.

BOUNDED RATIONALITY

Theory of bounded rationality has its inception a year back and was initiated by H.A. Simon (Simon 1957). Decision makers are to be viewed as boundedly rational and aim to satisfy emotional needs rather than maximizing the utility. According to him, the decision making is a course of search guided by the individual aspiration levels. Aspiration levels are defined as a value of the individual goal that needs be attained through the satisfactory choice of the alternatives. In case of personal finance and personal financial planning, goal can be the return maximization, security or better retirement plan etc.
Behavioral finance theory argues for the failure of rational decision making as an expressive form of human behavior. Bounded rationality states that investors are intended to be rational or are goal oriented as well as adaptive. However, due to the cognitive & the emotional architecture of human behavior, sometimes, investors fail in important decisions. This limit of the rationality in decision making is termed to be the bounded rationality in behavioral finance. Personal finance and the personal financial planning are highly influenced with such attitude. Limits on the rational adaptation can be of two sorts: procedural limits and substantive limits. Former one limits the approach to make decisions whereas the second affect specific choices directly. In case of personal finance decision, procedural bound will cover how one will make a choice to invest whereas the substantive bound of individual will be related to the investment decision to invest in a particular stock.

PERCEIVED INFORMATION

Kahneman and Tversky (1983) have stated that in the individual decisions, the mulish appeal resembles perceptual delusions over and above the computational errors. Personal fiancé and financial planning are highly affected by the current state of the individual’s perception about a particular situation. Consistent information, which is in line with our existing mindset, is easy to be perceived and processed. The perceived information matters much for the individual finance. It is human nature that, mind strives impulsively for consistency while making decisions and the inconsistent information tends to be overlooked by individuals. These may be perceived in a distorted way or will be attempted to fit in accordance with the existing assumptions and beliefs. Thus, the interpretation of new information is backed by the perceived ones in a way so as to reinforce the existing beliefs (Clarke and Statman, 1998). For example, individuals will interpret the economic indicators in accordance with their current level of the perceived information and make decisions accordingly.

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PSYCHOLOGICAL BIASES

Biases are defined as the unjustifiable preferences or importance given to particular choices by the individual. Diverse patterns of human behavior have been documented by cognitive psychologists for psychological biases. There are many patterns, which impact on the individual investor decision-making and these are explained below:
Heuristics: Heuristics means mental shortcuts for decision processes. Although, such heuristics make the decision much easier but, in the complex investment world, heuristics may result in poor investment decisions. These can lead to biases and as a result in suboptimal investment decisions. For example, according to the 1/n heuristic, investment is spread evenly over different investment products neglecting the consideration of the riskiness of the alternatives. For example, if there are three funds, each 1/3rd should be invested into each without looking at the risk associated.

Gambler's fallacy: This biasness is resultant when investors due to psychological factors predict inappropriately that any pertaining trend is going to be reversed. Such an illusion may lead to the purchase or sale of any specific share and an additional risk exposure.
Overconfidence: Psychological bias in the form of overconfidence leads individual investors to have a false opinion that they are better at selecting the investment, manager and/or investment sector. Overconfident can manifest itself in many ways for example in trading behavior (Barber and Odean, 2001).

  1. Mental Accounting: The propensity of individuals to arrange the world into separate mental accounts is known as the mental accounting concept, which can lead to inefficient decision-making. This largely affects personal financial decision. For instance, an individual may possibly borrow at a lofty interest rate for purchasing any consumer good, whereas simultaneously save at comparatively lower interest rates for its child’s college fund (Power, 2010).
  2. Framing: In behavioral finance, framing means choosing a particular word or set of words to present any given set of facts. It has a direct influence over the choices of investors. Prospect Theory is developed on this concept by Kahneman and Tversky (1979). In this, it has been observed that different from the expected utility theory, individuals give different weights to gains and losses with different associated probabilities. Framing supports a tendency of individuals to take higher risks to avoid losses as compared to the motive to secure gains (Stephen and Hasseldine, 2007).
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ILLUSIONS AND DECEPTIONS

Another element of cognitive bias is the individuals’ illusion of control. This illusion causes individual to act as if he were able to apply control especially where such control is impossible or unlikely to be observed. Such control, in the context of investment, covers the capability to recognize the out-performers of the future. Illusion of control together with the overconfidence concept explains the reason behind many investors' choices to invest in actively managed funds rather than the tracker funds, when they outperform and have lower charges (Shafir, Diamond and Tversky, 1997).

According to a study (Rhodes 2000), the relative past performance of actively managed funds is not an indicator or assurer of its future performance. Langer (1975) argues that people find it hard to admit that the investment returns or better the decision outcomes may be random. Langer attempts to distinguish between the chance events and the skill events. According to him, skill events involve a simple causal link connecting behavior and the outcome of a decision, whereas chance events’ outcomes are random in nature. But, individuals have illusions about this concept and often see the chance events as skill events. There can be considerable evidence found in the literature where investment managers have been proved to be unable to consistently out-perform in the stock markets (Jennings, 2005). Thus, the outcome of investment management is random in nature. But since the investment managers backed by analysis engage in skill behavior, they hope as if the portfolio performance is controllable, which is actually not. Thus it can be inferred that the personal finance and personal financial planning are dependent on the illusion and deceptions of individuals.

ACTIVATION

After making a decision, it is not mandatory for the individual that he is going to act on it; some motivation still is needed to initialize the action. In behavioral finance, presence of inhibition and procrastination in the activation stage of any investment decisions are identified. In case, decisions are already made, still they will not be implemented until sufficient positive motivation is there to overcome the inclinations and feelings, which restrain the action (Neukam and Hershey, 2003).

Status quo bias along with the conservatism tends to restrain the action by influencing the investors against change. As per the status quo bias, investor is inclined towards retaining an existing investment rather than switching to a new one, on contrary the conservatism leads to investor’s reluctance to change in opinion. This fear will prevent an action.
For instance, a sturdy drive for plans of saving for retirement may be offset by a higher level of fear regarding the course of planning. A strong wish to build up wealth for the retirement may be offset by stock market risk fear or a doubt on the financial services industry. Thus the elements responsible for activation should be treated carefully in personal finance and personal financial planning by the advisors.

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CONCLUSION

The above discussion on the behavioral finance and its elements throw a light on the importance of these behavioral aspects in the personal finance and personal financial planning decision. Behavioral finance explains the influences of emotions and cognitive errors on the investors as well as the stock market glitches like bubbles and crashes. According to Warren Buffett, investing is just not a game where the higher IQ wins, but once the person has an ordinary intelligence, only a temperament to control the investment urge due to which other people have dragged into trouble is enough. Decisions regarding such plans are influenced by the individual’s behavioral traits and are governed by theories of behavioral finance. There are some particular drivers in behavioral finance theory which drives the individual decisions regarding the personal fiancé as well as personal financing such as individual biases, risk appetite, information processing attitude and many more.

REFERENCES

  1. Benartzi, S. and Thaler, R.H., 2004. Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving. Journal of Political Economy. 112(1/2), pp. S164-S187.
  2. Cain, D.M., Loewenstein, G. and Moore, D.A., 2005. The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest. Journal of Legal Studies. 34(1), pp. 1-25.
  3. Clarke, R.G. and Statman, M., 1998. Bullish or Bearish. Financial Analysts Journal. 54(3), pp. 63-72.
  4. Dan, M., 2000. Effective Financial Planning in the Presence of Judgmental Heuristics. Journal of Financial Planning. 13(4). pp. 130-134.
  5. DeBondt, W., Forbes, W., Hamalainen, P. and Gulnur, M., 2010. What can behavioural finance teach us about finance? Qualitative Research in Financial Markets. 2(1). pp.29 – 36.
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