By: Riya Fernandes
Do all investors always choose the ideal course of action? Do they ever commit errors? Indeed, they do. If flawless financial decisions could always be made simply by conducting financial analysis or researching the industry, reality would be very different.
However, this is only a hypothetical situation; in reality, we are all motivated by emotions, a lack of self-control, personal prejudices, and a host of other factors that occasionally cause us to act irrationally and result in poor financial decisions.
Therefore, behavioral finance examines the processes involved in making financial decisions, including how often making irrational choices can have unanticipated financial repercussions. It also discusses the elements that affect decision-making. It contradicts the conventional opinion that has been held for long that investors make rational judgments and are not particularly influenced by social or emotional considerations.
An underappreciated but important issue for discussion is behavioral finance, which developed from behavioral economics. Investors benefit from being able to compare their perceptions to the truth. They may need to consider the facts rather than relying just on their convictions.
Let's continue ahead with some basic terminology used in behavioral finance that may even cause you to reconsider any risky financial behaviors you may be mindlessly adhering to.
Herd Behavior is first. When you make investment decisions based on herd mentality, you are acting in a particular manner. Before investing, you don't conduct your own research or analysis; instead, you follow others’ financial judgments without question. More specifically, you follow the financial decisions of a majority.
The following is an Emotional gap or interval. The emotional gap idea refers to the situation in which your feelings, particularly those of fear, greed, worry, or enthusiasm, dominate other rational considerations, such as your research or analysis, when you are making financial decisions. Either of these feelings has an impact on your financial choices. This is a significant reason why people don't make the right financial decisions at some point.
The third notion in the list is anchoring, based on the fact of the extremely high influence a benchmark price has on a person's decision-making. It makes investors hold to a fixated figure, ignore additional indications of worth, and change their beliefs and behavior accordingly.
The fourth factor is self-attribution; if someone overestimates their own knowledge or abilities when investing, they are likely to make poor choices. Such investors are likely to credit themselves for successes, while blaming external factors when things go wrong. People make this error by not seeking the advice of financial or investment professionals.
Mental accounting is the last concept. It refers to the way we classify money, or our inclination to handle it in various ways depending on its source or intended usage. Different ways in which we categorize our money can lead to unreasonable or irregular financial behavior.
This article about behavioral finance was brief, but if you're interested in learning more, you may explore Financial Psychology or Behavioral Economics to become knowledgeable about the topic.
Every action we do affects how we feel and how we make decisions. However, while making financial decisions, or more particularly, investing or planning them, it's critical that we avoid letting prejudice, overconfidence, or our emotions take control. Therefore, regardless of an individual's professional career or lifestyle, mastering at least the fundamentals of behavioral finance is essential.
Linking below some behavioral finance books for you via the good reads, if you are keen about investments, markets, behavioral finance and more.
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