This week’s post is going to explore a topic I’ve perpetually been fascinated about – “Behavioural Finance”, specifically the various biases we might fall victim to!
To provide you some context, Traditional Finance [TF] assumes that investors are “rational” decision makers and have access to perfect information equally. It characterises investors as risk averse individuals who choose the investment providing maximum return for a given level of risk. According to TF, whenever individuals encounter new information, they update their current beliefs using Bayes Theorem. This is where the concept of “Rational Economic Man” or Homo Economicus becomes very important. As a result of such rational investment decision making, markets are consequently said to be efficient and the prices are reflective of all the information out there!
Now in contrast, Behavioural Finance [BF] treats individuals as depicting “normal” behaviour, who might be susceptible to biases both cognitive and emotional and like you must have obviously guessed, we humans aren’t always “Rational”!
Well, think about it, every action we perform is not motivated by our own self-interest, it could be for the greater good of man-kind (for instance, Philanthropy, Altruism or generous actions like sharing your pizza). Our willingness and ability to take risk might vary based on the circumstance (we can demonstrate traits of being risk-averse, risk-neutral or risk-seeking). And we definitely don’t update our beliefs when exposed to new information using “Bayes Theorem” (right?). Consequently, this leads to the investment decisions being taken to be sub-optimal.
Therefore according to the theory of “Bounded Rationality” in Behavioural Finance, we strive to make the most rational decision given the limitations of our cognitive capabilities, shortage of time and cost considerations. Instead of looking through ALL the possible scenarios and picking out the MOST optimal decision, humans generally settle with the best possible decision which is satisfactory (but not optimal) under the given circumstances. The term specifically coined for this is “satisfice”. As a consequence of the market participants deviating from optimal behavior, the markets deviate from efficiency.
When we make investment decisions, we’re susceptible to certain irrational thought processes, which lead to sub-optimal or erroneous decision-making. These biases can be categorised as:
(a) Cognitive Errors: Can arise from faulty reasoning, erroneous information processing, data issues, etc. Cognitive errors are relatively more manageable as compared to Emotional Biases and can be reduced or rectified.
(b) Emotional Biases: These most likely arise from our intuition, thought processes and are emotionally driven. Thereby making them more difficult to detect, manage and rectify. Emotional biases in most investment decision making processes have to be accommodated rather than eradicated.
Keep in mind, the cognitive errors and emotional biases described in this post actually overlap with the concepts from the larger domain of Social Psychology.
“For psychological science (the most fascinating science, methinks), the world around us is a living laboratory in which we observe powerful social forces at work in others . . . and in ourselves.”– David Myers
And that’s a wrap for this week! 🙂 Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
To receive freshly brewed Finance articles every week, subscribe below.