Behavioural Finance: Understanding the Psychology of Financial Decision Making

Behavioural finance is an interdisciplinary field that combines insights from psychology and economics to understand why people make financial decisions.

It is a relatively new field that has gained popularity in recent years, as it offers a more holistic and realistic understanding of how people make financial decisions.

The field of behavioural finance has grown rapidly over the past few decades, with new research and insights being published regularly.

Bias and Heuristics

One of the key insights from behavioural finance is that people are not always rational in their financial decisions. They are often influenced by emotional and cognitive biases that can lead to poor decision-making.

For example, people may be overly optimistic about their future prospects, or they may be overly influenced by recent past events.

Behavioural finance research has identified a wide range of biases and heuristics that can influence financial decision-making.

These include:

• Confirmation bias: people tend to seek out information that confirms their existing beliefs while ignoring information that contradicts those beliefs.

• Overconfidence bias: people tend to overestimate their own abilities and the accuracy of their predictions.

• Anchoring bias: people tend to rely too heavily on a single piece of information or anchor when making decisions.

• Representativeness bias: people tend to rely on stereotypes and past experiences to make judgments about future events.

• Herding bias: people tend to follow the actions and decisions of others, even when those actions may not be in their best interest.

These biases and heuristics can have a significant impact on financial decision-making.

For example, people may invest in risky stocks because of overconfidence, or they may hold onto losing investments because of the anchoring bias.

Emotions and Financial Decision Making

Another important aspect of behavioural finance is the role of emotions in financial decision-making.

Emotions such as fear and greed can have a significant impact on financial decisions. For example, fear can lead to a reluctance to invest in the stock market, while greed can lead to overinvestment in risky stocks.

Behavioural finance research has shown that emotions can be regulated and managed through techniques such as mindfulness and emotional regulation.

Context and Framing: Behavioral finance also highlights the importance of framing and context in financial decision-making.

For example, people tend to be more risk averse when the potential losses are framed as certain, as opposed to probabilistic. This highlights the importance of understanding how context and framing can influence financial decisions.

Real-world applications

Behavioural finance has significant practical applications in the real world. For example, it can be used to design better financial products, such as savings accounts, that take into account the impact of emotional and cognitive biases on decision-making.

Behavioural finance can also be used to improve financial education and literacy by teaching people how to recognise and manage their emotional and cognitive biases.

In the field of wealth management and investment, behavioural finance can be used to improve portfolio management and risk management. For example, by understanding the impact of emotional and cognitive biases on investment decisions, wealth managers can help their clients make more informed and rational investment decisions.

Additionally, behavioural finance can be applied in the field of retirement planning.

By understanding the emotional and cognitive biases that can impact retirement savings decisions, financial advisors can help clients make more informed decisions about how much to save and when to start withdrawing from their retirement savings.