Decoding behavioural finance

Behavioural finance explores how psychological factors influence financial decisions, challenging the assumption of rational decision-making in traditional finance. It emphasises the impact of emotional, biased, and cognitive errors in shaping investor behaviour, often leading to irrational market choices.

A key concept is overconfidence, where investors overestimate their ability to predict market outcomes, frequently resulting in excessive risk-taking. This can lead to disastrous decisions, as they may ignore market warning signs based on prior successes. Another important bias is loss aversion, the tendency to feel the pain of losses more acutely than the pleasure of gains. This fear of losses can make investors overly cautious, causing them to hold onto poor investments in the hope of a rebound, potentially preventing them from achieving better returns.

Herd mentality occurs when investors follow the crowd, often inflating asset prices during market booms and creating bubbles that eventually burst, leading to significant losses. Similarly, during downturns, panic selling can exacerbate losses. Anchoring arises when investors cling to an initial price or piece of information, hindering rational decision-making. For instance, they might hold onto underperforming stocks due to the original purchase price, even when the company's fundamentals have deteriorated.

By recognising these biases, investors can develop better strategies, such as diversification, periodic reviews, by maintaining a long-term focus. Self-awareness of emotional biases can lead to more rational decisions, ultimately improving financial outcomes.

Arnab Chowdhury

North South University

arnab.chowdhury@northsouth.edu