Behavioural Finance : Meaning, Types of Biases and Approaches

               Many of us may have a doubt or a curiosity that what kind of bias lead to loss of investments or may be you are looking for the different kinds or types of biases that an investors may go make while making a decision. To understand this type of question you need to understand Behavioral Finance which we will be discussing in this article.

Behavioural Finance

          Behavioural finance is field of finance that deals with psychology based theories which explains about stock market anomalies such as rise and fall in the stock price.

          In simple words we can say that how securities price fluctuates independent of the any corporate actions. The role of behavioural finance is assist market analyst and investors to understand the price movements in the absence of the changes on the part of company.

          In Behavioural Finance it is assumed that the information structure and distinctiveness of market participants influences the individuals investment decisions and also the market outcomes

To understand well lets look into an example

          Lets consider a situation where a lawsuit is formulated against a X company and the investors remember that when this had happened earlier the price of the company had down as a result investors sold their investors which led to decline in the value of the security’s value.

          At the same time the investors in the other companies of same industry feared that the similar lawsuit can be brought against other companies in the industry. Thus thinking this they sold their holdings as a result of which the securities of that particular industry got declined.

          This scenario came in picture because none of the companies in that industry took action which resulted in reduced their intrinsic value of the securities.

Key Concepts or Biases in Behavioural Finance

§  Anchoring

§  Mental Accounting

§  Confirmation and Hind Bias

§  Gambler’s Fallacy

§  Herd Behaviour

§  Over reaction and availability bias

§  Overconfidence

§  Denial Bias

§  Representative Bias

§  Framing Bias

Now let us try to understand this one by one

§  Anchoring :

Anchoring in behavioural finance refers to the one’s ideas and opinions should be based on the appropriate facts and figure in order to be considered as valid.

§  Mental Accounting:

Mental Accounting refers to the tendency people to separate accounts based on variety of subjective criteria like the source of the money and intent for each account.

§  Confirmation and Hind Bias:

Confirmation in behavioural finance refers to a preconceived opinions of an individual. We have often saw that people pay attention to those opinions that support their opinions rather than rational one where it become highly difficult for a individual to discuss about it in rational manner.

While Hind Bias refers to the bias where a person believes that the commencement of certain event in past which has took place was completely predictable and would been understood but the reality is that the event cannot be practically predicted.

§  Gambler’s Fallacy:

We all know that in investments certain things are being predicted by the investors which is based on probability. But lack of understanding can often lead to incorrect assumptions and predictions about the commencement of a particular event. These incorrect assumptions and predictions are referred to as Gambler’s Fallacy.

§  Herd Behaviour:

If we careful observe the individuals there are individuals who try to mimic or follow someone else or a large group actions without thinking whether the individual or group have made their decisions rational or irrational.

§  Over reaction and availability bias:

We all know the importance of information in the stock market. This bias comes into picture when an individual or a large of investors over react which some information is comes to market and all the investors would start making their decisions based on the new information which is out as a result of which the security’s price start fluctuating because the new information made more than the real impact which gives rise to the bias referred as Overreaction and Availability bias.

§  Overconfidence:

This is the error that takes place when we overestimate or amplify an individual to perform certain particular tasks.  

§  Denial Bias:

This bias comes into picture when an investors starts denying the certain facts because of some reasons like the investment was held by investor for long period of time or other. The constant denying of information leads to the bias referred as denial bias.

§  Representative Bias :

This is the bias that where two or more similar events takes place and the individuals thinks that they are highly co-related with each other which also confuses to the individuals. But in reality they aren’t connected to each other. Such a bias in behavioural finance is referred to as Representative Bias.

§  Framing Bias:

This is the bias where an individual makes the decisions based on how the information presented even opposing the facts itself. If the same facts are presented in two different manners then to different decisions are made by the same individual. Such a bias is referred as Framing Bias.

Approaches in Behavioural Finance for Decision Making

Different approaches recommended in Behavioural Finance for decision making

§  Reflexive : It refers the invoice or a gut feeling of the investor belief. This is a default option.

§  Reflective: This is a logical and practically based method that deals with deep thinking about a particular investment.

The bias that take places is because of the of the reflexive approach of the investors which means the more the decisions are based on the reflexive approach the more the chances of the biases. While if the investors follows reflective approach more then, the chances of bias eventually comes down because of more rational decisions.