Psychology Behind Financial Decisions
Behavioral finance is the study of how our emotions, thoughts, and behaviors influence financial decision-making.
Decoding Financial Choices
At its core, behavioral finance offers a profound insight into the human psyche, revealing how our emotions, biases, and cognitive limitations weave into the fabric of financial decision-making.
Whether it's the allure of a new investment opportunity, the hesitancy to take risks, or the complex dance with personal debt – behavioral finance holds the key to understanding it all.
Behavioral Finance vs. Mainstream Financial Theory
Mainstream financial theories assume rational actors, emotionless decision-makers, and perfectly efficient markets while behavioral finance challenges these assumptions.
Economy assumes rational behavior from people but psychology proves that human beings take dumb decisions repeatedly.
Behavioral finance revolves around understanding how psychological factors and biases influence financial decisions.
Few Core Principles:
Loss-Aversion Bias: People tend to fear losses more than they value equivalent gains. As per Thinking Fast and Slow by Daneil Kahneman, fear of loss is nearly twice as intense as the satisfaction derived from winning an equivalent amount.
Loss-Aversion Bias: People tend to fear losses more than they value equivalent gains. As per Thinking Fast and Slow by Daneil Kahneman, fear of loss is nearly twice as intense as the satisfaction derived from winning an equivalent amount.
Anchoring Bias: Examine how we tend to focus excessively on the initial information we receive, anchoring our perceptions and decisions.
Anchoring Bias: Examine how we tend to focus excessively on the initial information we receive, anchoring our perceptions and decisions.
Overconfidence Bias: Human beings confront the reality of overestimating our abilities, as exemplified by the surprising statistic that 93% of U.S. drivers believe they are better than average.
Overconfidence Bias: Human beings confront the reality of overestimating our abilities, as exemplified by the surprising statistic that 93% of U.S. drivers believe they are better than average.
Endowment Bias: If you own a certain stock, and even if there are potentially better investment opportunities out there, you might place extra value on your current stock just because it's already in your portfolio. This inclination to favor what you already own is called Endowment Bias.
Endowment Bias: If you own a certain stock, and even if there are potentially better investment opportunities out there, you might place extra value on your current stock just because it's already in your portfolio. This inclination to favor what you already own is called Endowment Bias.
Mental Accounting: Think of Mental Accounting as mentally categorizing your money for different goals, like retirement or a vacation. While this helps organize, it might lead to missed opportunities if you're overly strict with one fund and neglect others. It's a reminder to manage all your funds wisely for overall financial growth.
Mental Accounting: Think of Mental Accounting as mentally categorizing your money for different goals, like retirement or a vacation. While this helps organize, it might lead to missed opportunities if you're overly strict with one fund and neglect others. It's a reminder to manage all your funds wisely for overall financial growth.
Confirmation Bias: Recognize the tendency to seek information that confirms our pre-existing beliefs, potentially blinding us to alternative perspectives.
Confirmation Bias: Recognize the tendency to seek information that confirms our pre-existing beliefs, potentially blinding us to alternative perspectives.
In everyday life or decision-making, this bias makes us more likely to listen to people or seek out information that aligns with our existing views, and we might ignore or downplay anything that contradicts what we already think.
Sunk Cost Fallacy: Grapple with the challenge of letting go when we've invested time, effort, or money into a decision, even when the costs are irrecoverable.
Sunk Cost Fallacy: Grapple with the challenge of letting go when we've invested time, effort, or money into a decision, even when the costs are irrecoverable.
Good example can be averaging more money in stock going down just because you already own that stock - It’s like throwing good money after bad money.
Availability Bias: Contemplate the impact of relying on readily available information, sometimes leading us to make judgments that may not align with reality.
Availability Bias: Contemplate the impact of relying on readily available information, sometimes leading us to make judgments that may not align with reality.
Social Proof: Understand the influence of social proof, we look to others to determine appropriate behavior. Imagine choosing a stock because everyone else bought it - That's social proof. While it's natural to follow the crowd, it's crucial to make financial decisions based on your goals and research, not just what others are doing.
Social Proof: Understand the influence of social proof, we look to others to determine appropriate behavior. Imagine choosing a stock because everyone else bought it - That's social proof. While it's natural to follow the crowd, it's crucial to make financial decisions based on your goals and research, not just what others are doing.