What is Behavioral Finance: Findings and Advantages

Behavioral finance is a branch of finance that deals with emotional involvement in financial decision-making. This finance branch talks about the biases of human nature that impact our investment choices and, how it leads to the deviation from traditional economic models. 

In this article, we will be discussing behavioral finance along with its findings and applications.

Table of Contents

• What is Behavioral Finance?
• Findings
• Applications
• Biases Identified Through Behavioral Finance
• Advantages

What is Behavioral finance?

Behavioral finance is the area of finance that explores how psychology, emotions, and cognitive biases influence financial decision-making. It seeks to understand and explain how human psychology and emotions influence financial decision-making. While traditional finance assumes that investors are rational and act in their own best interests, it recognizes that people often make decisions that are influenced by biases and emotions.

Findings

Over the years, researchers in this field have uncovered findings that explain how our behavior can impact our financial outcomes. Following are the examples of some of the key findings in the field of behavioral finance:

• Emotional influences: Emotions can also play a significant role in financial decision-making. Fear and greed are two of the emotions that have a particularly strong impact. Fear of loss can cause investors to sell off assets too soon, while greed can lead them to take on too much risk in the hopes of earning higher returns.
• Cognitive biases: It can have a significant impact on financial decision-making. For example, the confirmation bias can cause people to get information that confirms their existing beliefs and ignore information that contradicts them. The availability bias can lead people to overestimate the likelihood of rare events based on vivid examples they have seen in the media.
• Herding behavior: People often engage in herding behavior, meaning they follow the crowd and make decisions based on what others are doing rather than on their own analysis of the situation. This can be seen in market bubbles, where investors pile into a particular asset class because everyone else is doing it, rather than because they have done their own due diligence.
• Anchoring: This occurs when people rely on an initial piece of information while making a decision. For example, if an investor is given a target price for a stock, they may be more likely to hold onto that stock even if new information emerges that suggests it is no longer a good investment.

Applications

Here are some examples of the applications of behavioral finance:

• Retirement planning: Behavioral finance can be particularly useful for this purpose. People often struggle to save enough for retirement, in part because they underestimate how much they will need and how long they will live. It can help individuals set more realistic goals and make better decisions about how to save and invest for retirement
• Financial advising: Financial advisors can use insights from behavioral finance to help their clients make better financial decisions. By understanding the biases and emotional influences that can impact decision-making, advisors can help clients avoid common pitfalls and make more informed choices.
• Corporate finance: Behavioral finance can also be useful in the realm of corporate finance. For example, companies can use insights from behavioral finance to design better incentive systems for their employees, taking into account the ways in which people respond to different types of rewards and punishments.
• Investing: Investors can also benefit from the insights of behavioral finance. By understanding their own biases and emotional influences, investors can make more informed decisions about what to buy and sell, and when. This can help them avoid common mistakes such as buying high and selling low.
• Public policy: Finally, policymakers can use insights from behavioral finance to design better policies that take into account the ways in which people actually behave. For example, policies that are designed to encourage people to save more for retirement may be more effective if they take into account the biases and emotional influences that impact decision-making.

Biases Identified Through Behavioral Finance

Behavioral finance is the study of emotional impact on our financial decision-making. The following biases have been identified: 

1. As per the study of behavioral finance is the human tendency to feel more strongly towards losses as compared to gains. This means our emotions towards financial losses stay with us for longer. Due to this, the human brain prevents itself from taking any further risks, thus, leading to missed opportunities to make profit.
2. Another bias as per behavioral finance is the nature of excessive risk trade. This is the opposite of the first bias since many traders invest more than their risk tolerance which, in turn, leads to huge financial losses. 
3. One of the major biases involves getting influenced by the information presented. This is leveraged by market movers as they know how to play with the psychology of investors with smaller capital to invest.

Explore:

Investing courses

Corporate finance courses

Advantages of Behavioral Finance

There are several advantages of using insights in financial decision-making.

• More accurate models: Traditional financial models assume that people always act in a rational manner and in their own best interests. However, as we know from the findings of behavioral finance, this is not always the case. By incorporating insights from behavioral finance, models can be more accurate and better reflect the reality of how people actually make decisions.
• Improved decision-making: Behavioral finance can help individuals and organizations make better financial decisions by providing a better understanding of the biases and emotional influences that can impact decision-making. By recognizing and accounting for these factors, individuals and organizations can make more informed choices and avoid common mistakes.
• Better risk management: One of the key advantages of behavioural finance is its ability to help individuals and organizations manage risk more effectively. By understanding the ways in which people tend to react to different types of risks, individuals and organizations can develop strategies for mitigating risk and protecting themselves against potential losses.
• More effective communication: Behavioral finance can also be useful in the context of financial communication. By understanding how people tend to interpret and respond to different types of information, financial professionals can develop more effective strategies for communicating with their clients or stakeholders.
• Understanding Perspectives: It helps individuals and organizations develop greater empathy and understanding for the perspectives and behaviors of others. By recognizing the ways in which our own biases and emotions impact decision-making, we can develop a greater appreciation for the challenges faced by others and work more effectively with them to achieve common goals.

Explore risk management courses