What is Financial Behavior?

Last Updated: 22 Jul 2022

In stark contrast to traditional financial theories, behavioral finance states that financial decisions made by an investor are influenced by personal biases and psychological influences. Accordingly, the financial behavior of investors has an impact on inconsistencies in the market, especially the stock markets. Sudden price rises or falls, market bubbles, etc. may be attributed to the financial behavior of the investor. But, how do you define financial behavior?

What is Financial Behavior?

The definition of financial behavior is rather complex. Analyzing financial behavior aids in understanding the price trends across various industries and sectors. The efficient market hypothesis assumes that the financial behavior of investors is rational. Price movements are dependent on market conditions and are not influenced by the financial behavior of investors.

On the other hand, behavioral finance assumes that investors are not rational, investment decisions are subject to psychological biases. Also, behavioral finance presumes a degree of normalcy and self-control tendencies amongst investors. The following five concepts broadly cover the concepts of behavioral finance:

1. Mental Accounting

   Mental accounting refers to the tendency or inclination for a specific investment purpose. For example, a risk-averse investor may be wary of investing in aggressive funds.

2. Herd Behavior

   The form of behavior is when an investor imitates the investment decisions of a majority of investors. Herd behavior leads to sudden rallies in stock markets. An example of herd behavior is when stock market legend Rakesh Jhunjhunwala shares his stock market tips. Being one of the most successful stock traders in India, many investors follow in his path, which has been often witnessed and is a classic sign of herd behavior.

3. Emotional Gap

   Decisions taken under extreme emotional duress such as fear, anxiety, etc. are on account of an emotional gap. Emotions tend to impact the rationality of investors. Panic selling at the advent of the pandemic is an example of an emotional gap.

4. Anchoring

   Anchoring refers to budgeting. This is when investment decisions are based on the liquidity available after factoring in miscellaneous needs.

5. Self-Attribution

   Decisions made based on excessive dependency on the investor’s knowledge lead to self-attribution. Objectivity takes a back seat and overconfidence in one’s expertise facilitates decision making. This can often lead to losses or a profit in a few cases.

What are Decision-Making Errors and Biases?

The definition of financial behavior is further explained by some personal biases and tendencies surrounding behavioral finance:

1. Confirmation Bias

   Investors can easily accept information that corroborates with a preconceived notion about an investment. The legitimacy of such information is not evaluated rationally.

2. Recency Bias

   Also known as experiential or availability bias, an investor’s experience or knowledge of recent events makes them biased. For example, after the recession of 2008, many investors refrained from investing with the bias of reoccurrence.

3. Loss Aversion

   This phenomenon occurs when an investor focuses on probable losses rather than gains from the market. The priority lies in avoiding losses and not earning profits. Some investors would want a higher return to compensate for losses, irrespective of the degree of risk involved.

4. Deposition Bias

   In line with loss aversion, investors tend to hold onto losers and dispose of high-performing investments. Short-term gains tend to cloud the investor’s judgment about the potential investment opportunity it presents. Whereas investments that are trading at losses are held for longer with the hope that the initial price will be recovered.

   Often, investors are quick to accept and appreciate efficient investment decisions but reluctant to accept their mistakes. Thus, the investment horizon is often dependent upon the purchase price of the investment without any consideration of fundamentals or other attributes.

5. Familiarity Bias

   Investors have a certain degree of comfort with domestic companies, locally owned companies, well-known companies, etc. which influences their decision making. As a result, diversification for such investors is limited.

How to Overcome Behavioral Finance Issues?

For investors, there are methods to mitigate adverse financial behavior tendencies. These include:

1. Reflective Decisions

   Decision-making may be reflective or reflexive. However, reflexive decision-making is intuitive and ingrained by default. It is affected by emotions and lacks rationality. On the other hand, the reflective approach is objective and analytical and may involve more effort and focus on the process. It is essential to focus on the process than the outcome.

2. Adequate Planning & Execution

   Behavioral finance emphasizes adequate planning, preparation, and timely execution. Hasty and unplanned decision-making tends to have long-term repercussions.

Lastly, many studies have established that markets are not completely efficient, and the study of behavioral finance is imperative to understand market irregularities and predict future trends. By researching the psychological biases of investors, behavioral finance provides a pattern for market movements and promotes effective decision-making.