Finance-related decisions are a daily activity today. Investors or professionals working in Financial institutions are challenged to make smart and intelligent investment decisions. While traditional finance and investment theories stress the importance of considering risk and return factors for maximising profit, a modern theory has evolved, suggesting that multiple biases impact investment decisions. This theory named behavioural finance has become highly popular among economists, financial analysts and investors. This blog aims to delineate the concept of behavioural finance and explore its implications for corporate investment strategies.
Defining Behavioral Finance
Behavioral Finance is a field of study that evolves diverging from traditional finance theories. It is a study that focuses on psychological influence on the behaviour of financial analysts or investors. This theory stands on the premise that investors are not always rational and that their self-control is limited and influenced by their own biases. Traditional investment or financial theory posits that investors make investment decisions based on their rationality and risk and return factors. Behavioral Finance, on the contrary, suggests investors make investment decisions based on psychological and emotional factors to a great extent.
The traits central to Behavioral Finance may be classified as hereunder:
I) Investors are not rational and they are normal
ii) Investors have limited self-control
iii) They are significantly influenced by their own biases
iv) They are likely to make wrong decisions as they are liable to make cognitive errors
The biases that impact the decisions of investors according to behavioural finance are:
Self-deception: This premise limits how we learn. When one mistakenly perceives to know more than what they actually know, it leads to missing out on information that they require to make informed decisions.
Heuristic Simplification: This implies information-processing errors
Emotion: This implies making decisions based on the current state of emotion. This may result in making a decision that may deviate from rational thinking
Social Influence: This means making decisions influenced by others.
Five Major Concepts Encompassing Behavioral Finance
Mental Accounting: This refers to people's proclivity and inclination to allocate money for specific purposes.
Herd behaviour: This refers to the tendency of people to mimic the majority of the herd's financial behaviours. For example- Herding in the Stock market.
Emotional Gap: Implies making decisions based on extreme emotions and emotional strains like fear, anger, excitement or anxiety.
Anchoring: This implies associating spending level with a specific reference like a budget or varied satisfaction utilities.
Self-Attribution: Implies the proclivity to make decisions based on overconfidence in one's skills or knowledge.
Implications of Behavioural Finance on Corporate Investments
Let us shed light on how behavioural finance impacts corporate investment decisions in numerous ways:
Loss Aversion: Often corporate investors are driven to make irrational decisions due to fear of losses. This may include premature selling of assets with the target to avoid further losses or declines. Loss aversions also can result in suboptimal portfolio management and missing out on opportunities to make long-term profits.
Over and Under Reaction: One of the characteristic traits of behavioural finance is the tendency of corporate investors to overreact to new information resulting in exaggerated movements of prices. There is also a situation of underreaction where investor's underreaction to significant news may result in the slow adjustment of prices. However, if corporate investors understand these traits, it can empower them to capitalize even on the market inefficiencies.
Herding Behaviour: This exposes the human tendency to follow the crowd, particularly during uncertain or unreliable situations. Herd behaviour is liable to augment market volatility and result in crashes or bubbles. Corporate investors must therefore be mindful of these instances and be careful not to blindly follow the herd. They must instead rely on complete analysis and independent judgment.
Anchoring: Anchoring is a major error that may occur in the event of an investor remaining fixated on a reference point and is unwilling to value revision in comparison to new information. For example: the buying price of a stock. This kind of bias can result in prolonged holding of losing investments or premature selling of winning positions.
What are the Behavioural Biases that influence Investment Decisions?
To understand further the influence of behavioural finance in Corporate investment, let us understand the major types of behavioural biases that affect investment decisions:
Behaviour Biases: This implies the systematic error in the thought process and decision-making strategies of the investors which is liable to result in suboptimal investment decisions. These errors are frequently embedded within our emotions, cognitive constraints, and past experiences that are communicable in numerous ways. Some of the prominent examples of behavioural biases include:
I) Herd Mentality
II) Anchoring Effect
III) Confirmation Bias
IV) Loss Aversion
Cognitive Errors: This type of error, also referred to as Thinking errors occurs frequently in decision-making and reasoning and is liable to leave a crucial impact on investment decision-making. Often this error occurs owing to incomplete data or information or cognitive biases. One ideal example of cognitive error is overconfidence bias. In such an event, the investor has the false belief that his knowledge is sufficient and more significant than it actually is. This may result in the reduction of expected risks and high overestimation of expected returns. Some of the prominent errors within Cognitive errors include:
a) Confirmation bias: Seeking out information that validates the investor's beliefs
b) Hindsight bias: Overconfidence in one's ability to project future events
c) Availability Heuristic: over or heavy reliance on available information and failing to seek out additional necessary information
Having in-depth knowledge of these biases is essential to avoid expensive mistakes in making investments. Investors are required to seek out and gather as much information as possible and be flexible with other varying alternatives based on new information and evidence.
Behavioral finance is significantly influential in making investment decisions. It offers valuable insights about the various psychological factors with the potential to drive and shape business dynamics. Investors may rely on behavioural finance theory and build a comprehensive understanding of the hidden biases, emotions, and factors that can impact their behaviour in making decisions about corporate investments. Today, the business landscape is marked by evolved customer behavior and is significantly driven by human psychology. Hence, understanding behavioural finance is unprecedentedly important in today's corporate ecosystem.
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