Behavioural Finance

Behavioural Finance

Most people often devote rather waste a lot of time finding the next big investment , hot stock , fund , real estate and so on. However the most important thing that impacts every family’s overall financial well being is the area of behavioural finance. This is often a neglected area by most people. Behavioural Finance is the study of how emotions and psychology affect financial decisions.

Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. We all know that this is never the case and human emotions and psychology play a big role in any financial decision making process.

According to Gary Belsky and Thomas Gilovich, authors of a fantastic book, Why Smart People Make Big Money Mistakes And How To Correct Them, “Behavioural Finance or Behavioural Economics combines the twin disciplines of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they spend, invest, save and borrow money.”

There are several concepts in Behavioural Finance that you must understand. Some of them are:

Mental Accounting: Phenomenon of treating money differently based on its source. People generally treat money received on a game show differently from what they would it they had earned it.

A classic example was that of a lady on a show “Dus Ka Dum”. This lady, from a modest background, had won Rs. 10 lakh, which is a substantial sum of money. The next correct answer could have got her Rs. 1 crore or she would lose Rs. 9 lakh and take home Rs. 1 lakh. Instead of walking away with Rs. 10 lakh she bet on Rs. 1 crore and lost Rs. 9 lakh. Would that lady have bet Rs. 10 lakh that she earned on something as risky as this? Never ever but the very fact that Rs. 10 lakh was earned in not even 10 minutes and through a different source made her treat it differently.

Similarly, many people would treat a windfall from parents or other sources differently than they would if the money had come from the fruits of their hard labour.

Just because you have won a lottery, received a windfall or a gift does not mean that the money does not belong to you or that you need to treat it differently. Think of your money (all inflows and outflows) in terms of your balance sheet and not something that you bracket depending from where it has come from. Never act immediately when you receive a bonus or windfall. Think about it for at least 48 hours.

Decision Paralysis: You are afflicted with this one if you delay making investment decisions or cannot decide between investment choices. Some will talk to 10 different people but never end up doing anything. Mark Twain said, “20 years from now, you will be more disappointed by the things that you did not do than by the ones that you did do”.

Loss Aversion: This is how our feelings towards loss can force us not to exit investments, or wait too long or put in more money in an unfinished project. Have you ever watched a movie in a theatre that you felt was complete nonsense and a waste of time? Did you ever walk out of the theatre? Very few people will because they have paid Rs. 200 per ticket. This is a classic example of loss aversion.

Anchoring: This is one of the most difficult or complex behaviours to overcome. Let’s understand this with an example of Mrs. Kulkarni. “In December 2010, Builder X had offered Rs. 1 crore to my neighbour, Mr. Bhatia. Now 8 months down the line, he should at least offer me a higher price. My flat is much better than Mr. Bhatia’s. According to the builder, prices have started to go down (although he himself has not cut down prices on his project) and the last similar flat sold was at Rs. 80 lakh.” This is a classic phenomenon in real estate where buyers and sellers are anchored to a price. Well, the price is now down to Rs. 70 lakh and Mrs. Kulkarni is still holding her flat.

Anchoring is when you often hold on to a fact or figure and use that as the basis or reference point for making future decisions.

Seeing the rise in real estate prices since 2003, people believe that real estate can only go up. Similarly, equity market investors believed that the markets would always deliver at least 25-30% annually because equities had delivered 40% annually for a few years in the past . Decisions just based on such anchors are rudimentary and can be dangerous for your long-term financial health.

Overconfidence, Greed and Fear

These three very common emotions mostly depend on the external economic and your internal economic situation. People are extremely bullish during good times but the very same people chicken out during bad or tough economic times (even though their situation does not warrant so). You are afflicted with overconfidence if you think:

  • Real estate is the best investment and there is no way one can lose money in a real estate transaction

  • You have made a wise decision by buying an investment-oriented life insurance policy despite someone telling you a term plan is the way to go

  • You can identify the next Infosys of the market but can also easily explain the faulty choices you have made. You can identify all financial trends correctly

  • You don’t need a good advisor because you already know a lot

The less said about greed the better.

At the same time, you are afflicted with fear, if you are scared when the equity market goes down. People who wanted to buy real estate in 2007-2008 at any price were fearful in 2009 when the prices were down by around 25%. Fear often makes people commit the biggest mistake of all: “Doing nothing”.

If you understand these and other behavioural issues well, you can actually use them to your advantage. However, this would also require one to keep his ego aside, which can sometimes get difficult for very smart people.

“The Behavior Gap” by Carl Richards is another excellent book on behavioural finance. Look at a very simple powerful sketch on Greed and Fear by Carl.

Spend time on thinking whether you are really afflicted with any of these emotional biases. Your honest answers and actions to address these can secure your financial well-being.

 

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