Psychology and emotions play a key role in economic and financial decisions. People are influenced by past experiences, context and their own beliefs. The study of the effects of non rational factors on investment choices and markets is called behavioral finance.
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What is behavioral finance?
In investment choices, not only rationality matters. Psychology and emotions play a key role in determining economic and financial decisions. This assumption is the basis for behavioral finance, which studies precisely the effects of nonrational factors on investment choices and markets.
Behavioral finance was first discussed as early as the late 1700s with Adam Smith. But it is mainly in recent decades that studies and publications have accumulated, with contributions from different schools of thought.
The goal is to understand the behaviors of financial markets in relation to the behavior patterns of society and the individual. Specifically, people are influenced by several variables, including past experiences, context, one’s beliefs, and the format in which information is presented.
All of these factors drive, for better or worse, economic performance.
Emotions and financial choices
Emotions such as fear, greed, or pride can affect investors’ decisions. Especially in the most heated stages of trading, they can lead to irrational choices. At these junctures, past experiences and memories of poor choices can also influence future strategies.
Often, how the information was presented to the person who must make the final decision can also contribute to influencing investment choices.
It is not only about the clarity of the information, but also the nuances and tone that can go into influencing the investor’s perception.
The mind tends to reason rationally, but it can still run into some cognitive biases.
Among the most common are: overconfidence or overoptimism, the illusion that one is in control of phenomena that are actually uncontrollable, and the belief that one wants to maintain the status quo because one is actually unable to cope with strategic change.
A bias that is often in place is to base one’s decisions on beliefs that stem from past experience. Thus with the illusion that even in very different situations the same result can be achieved.
In making decisions, in addition to looking to the past for solutions, we look to those around us. This is the so-called flock effect. If the majority of traders make a decision in one direction, the investor tends to feel more justified in making the same decision.
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Market inefficiencies and losses vs. gains
It is not only the individual who moves irrationally. It can happen that markets move irrationally and especially inefficiently. From mispricing to anomalies on investment returns, the entire economic-financial community can have erratic behavior.
Loss aversion is a central factor as well as one of the most prevalent biases. This aversion is so strong that a loss, according to some theories, weighs 2.5 times more than a gain of the same magnitude in an investor’s history and choices.
Moreover, a loss can also push the investor in two opposite directions. In some cases it may lead him to take a risk to quickly return to profit in a kind of gamble.
The problem is that this often ends up making losses worse, because people invest irrationally, driven only by the desire to catch up. In other cases, it can drive those in a loss-making situation to keep the situation unchanged for fear of running into larger losses.