Lessons Learned in Behavioural Finance

In the past few articles, we have studied about how behavioral finance impacts financial markets more than one might believe. When the subject of behavioral finance was first created, it was thought of as being an unimportant subject. It was perceived as being a cross between financial theory and psychology. However, over the years, behavioral finance has gone mainstream. You can hear various market pundits advise their clients to use the principles of behavioral finance to make sound investment decisions. Many of these principles have been unveiled in the previous articles.

This article provides a summarized list of lessons learned. This can be thought of as a checklist that investors can look at in order to avoid investment mistakes.

Lesson #1: Investing is an Emotional Process

The assumption made in financial theories about investing being a completely rational process that can be undertaken with mathematical precision is actually incorrect. The vast majority of investment decisions are made emotionally. A lot of these decisions are based on ignorance, impulsiveness, etc. However, even the well thought of decisions actually involve some amount of bias.

Hence, from an investor’s point of view, the big lesson here is that they need to watch their own thinking. Successful investors are constantly on the lookout for inaccurate logical conclusions in their own thinking. Investor fallacies tend to be complicated since the human mind often subconsciously omits a lot of important information. Successful investors need to be vigilant and need to analyze their own thought processes.

It is also important to realize that since investing is inherently an emotional process, we should avoid mixing personal relationships with the same. For instance, we should avoid making investments or financial relationships with our friends or family members. Our relationship with them will skew our ability to rationally evaluate the investment options, and the odds are that we will end up making the wrong financial decision.

Lesson #2: Trend May not be Your Friend!

Investors often have an emotional response to market trends. This is because they believe that the market collective has better information than they are likely to have as an individual. However, we have already learned that this kind of thought process is the root cause of a herd mentality. Herd mentality, in itself, has fuelled many asset bubbles in the past. Hence, it is the investor’s duty to clearly evaluate their thought process and avoid blindly following the trend.

Lesson #3: Bias can Never be Eliminated

It is important to realize that even knowledge of behavioral finance cannot make investors perfect. This is because investing is inherently a game played between imperfect participants. It should be known that the goal of learning behavioral finance has to be to minimize biases and irrationality. If the goal is set as eliminating bias and irrationality, then it will be impossible to achieve. This is because of two reasons.

Firstly, decisions have to be taken at lightning speed in the market place. Investors do not have time to collate information, analyze it, and then make decisions. If they go through the entire process, then they are likely to miss the opportunity. Instead, most investors find it prudent to use shortcuts and make decisions. This skill can be honed to make better decisions, but the use of shortcuts cannot be completely eliminated.

Secondly, even the most sophisticated investors don’t have control over the subconscious decisions being made in their brains. Hence, they may not be able to completely eliminate bias.

Lesson #4: Context is Important

In finance textbooks, it is often assumed that investors who are making decisions look at each problem on its own merits. However, in reality, that is not the case. Investors are highly influenced by the context.

The same investor may make very different decisions about a trade based on whether their previous trade was profitable or loss-making. Sometimes it may not even be their own trade, which affects investor behavior.

Instead, investors may be affected by the news regarding the boom or bust in the market. An investor who understands behavioral investing will understand the role context plays in their decision making and will try to minimize its impact.

Lesson #5: Sub-optimal may be Optimal

Traditional investment theories often try to find the optimal portfolio. They want to find the combination of assets that will generate the highest returns for them. However, behavioral finance practitioners know that such a quest is actually counterproductive. This is because investors often have neither the time nor the resources to find the best assets to invest in. Instead, most investors would be better off with a strategy called “satisficing.” Satisficing is about trying to achieve the best decisions within the bounds and constraints imposed on us.

Hence, if we were to summarize, it would be fair to say that the study of modern-day finance and financial markets is incomplete without the study of behavioral finance. It is important to educate the students on the value of behavioral finance and also encourage them to observe human biases in action in day to day life. This will enable them to be better prepared for making investments in the financial markets.