Behavioral Finance in Personal Finance

Prof. S. Thilak, Assistant Professor, SIMS

Behavioral Finance

            The research-based discipline that documents a range of our financial habits with development mental short cuts or behavioral biases which can affect all types of decision making including financial matters relating to money and investing. It also provides evidence that are not rational when dealing with money related decision-making and non-rational behavior  and  somewhat predictable systemic and repeated.

Mental Short cut

            Our brain takes mental short cuts due to the information overload as a result it will have incomplete information for decision making.

 

Types of behavioral

            Emotional group is subdivided in to four, they are Overconfidence, Loss Aversion, Disposition and regret. Information processing group covers the areas like Framing, and Anchoring and the last cluster covers the herding.

Emotion

Overconfidence: Human tends to believe that they are rational and naturally optimistic having an inflated view of one’s own ability and unwarranted confidence in their decision making and often have an unreasonable belief that good things will happen to them and bad things to other people.

Loss Aversion: Attitude towards loss, people tend to be oversensitive to loss and feel the pain about 2 and 2.5 times as strongly as they feel pleasure of gain and pain of loss.

For example: which job would you accept? A job where you’re getting a salary cut each year.

1. 6lakhs in the 1^st year, 5Lakhs in the 2^nd year and 4 lakhs in the 3^rd
2. 5lakhs in the 1^st year, 4.5 lakhs in the 2^nd year and 5.5 lakhs in the 3^rd year.

Mostly many of the people will choose option 2 because of the increase in the salary but if you sum up both the salary 6+5+4=15 lakhs, but in option 2 3.5+4.5+5.5=13.5lakhs. The value of the option one is higher this where the loss aversion.

Disposition Effect: Individuals tend to sell winners and hold loser, an overall effect of decreasing the overall investment. By selling an investment at a gain it becomes a winner and the investor enjoys the pleasure associated with a good investment. By sagging on to the losers, an investor can defer the pain associated with incurring a loss and can spoil in the belief or hope that the investment may come back and become another winner.

Regret: Arises when an individual perceives a bad outcome from a decision that they made in the past. Usually more regret associate with taking action that turn our worse and inertia not taking an action that would have benefited us.

(inertia means that people fail to get around to taking action often even on things they want)

Information Processing

Framing: People tend to lose sigh of the big picture and focus on the particular issue in front of them at that time. Narrow framing refers to the tendency to use relatively narrow frames of reference for decision making.

Anchoring: View of things by creating an artificial frame of reference. Some anchors may have control over, and some don’t, but they can all affect view of which is actual. The judgement about things may or may not be truly relevant to the decisions that are trying to make, but they have an impact anyway.

Herding: People’s decision can be influenced by what people around them are doing. Which refers to herd’s instinct to behave in a group. After decision are made as group which may counteract as a particular bias or it may strengthen it or could create new biases.