Behavioural Finance : Meaning, Types of Biases and Approaches (2024)

Many of us may have a doubt or a curiosity that what kind of bias lead to loss of investments or may be you are looking for the different kinds or types of biases that an investors may go make while making a decision. To understand this type of question you need to understand Behavioral Finance which we will be discussing in this article.

Behavioural Finance

Behaviouralfinance is field of finance that deals with psychology based theories whichexplains about stock market anomalies such as rise and fall in the stock price.

Insimple words we can say that how securities price fluctuates independent of theany corporate actions. The role of behavioural finance is assist market analystand investors to understand the price movements in the absence of the changeson the part of company.

InBehavioural Finance it is assumed that the information structure anddistinctiveness of market participants influences the individuals investmentdecisions and also the market outcomes

To understand well lets look into anexample

Letsconsider a situation where a lawsuit is formulated against a X company and theinvestors remember that when this had happened earlier the price of the companyhad down as a result investors sold their investors which led to decline in thevalue of the security’s value.

Atthe same time the investors in the other companies of same industry feared thatthe similar lawsuit can be brought against other companies in the industry.Thus thinking this they sold their holdings as a result of which the securitiesof that particular industry got declined.

Thisscenario came in picture because none of the companies in that industry took actionwhich resulted in reduced their intrinsic value of the securities.

Key Concepts or Biases in Behavioural Finance

Nowlet us try to understand this one by one

§ Anchoring :

Anchoring in behavioural finance refers to the one’s ideas andopinions should be based on the appropriate facts and figure in order to beconsidered as valid.

§ Mental Accounting:

Mental Accounting refers to the tendency people to separateaccounts based on variety of subjective criteria like the source of the moneyand intent for each account.

§ Confirmation and Hind Bias:

Confirmation in behavioural finance refers to a preconceivedopinions of an individual. We have often saw that people pay attention to thoseopinions that support their opinions rather than rational one where it becomehighly difficult for a individual to discuss about it in rational manner.

While Hind Bias refers to the bias where a person believes that thecommencement of certain event in past which has took place was completelypredictable and would been understood but the reality is that the event cannotbe practically predicted.

We all know that in investments certain things are being predictedby the investors which is based on probability. But lack of understanding canoften lead to incorrect assumptions and predictions about the commencement of aparticular event. These incorrect assumptions and predictions are referred toas Gambler’s Fallacy.

§ Herd Behaviour:

If we careful observe the individuals there are individuals who tryto mimic or follow someone else or a large group actions without thinkingwhether the individual or group have made their decisions rational orirrational.

§ Over reaction and availability bias:

We all know the importance of information in the stock market. Thisbias comes into picture when an individual or a large of investors over reactwhich some information is comes to market and all the investors would startmaking their decisions based on the new information which is out as a result ofwhich the security’s price start fluctuating because the new information mademore than the real impact which gives rise to the bias referred as Overreactionand Availability bias.

§ Overconfidence:

This is the error that takes place when we overestimate or amplifyan individual to perform certain particular tasks.

§ Denial Bias:

This bias comes into picture when an investors starts denying thecertain facts because of some reasons like the investment was held by investorfor long period of time or other. The constant denying of information leads tothe bias referred as denial bias.

§ Representative Bias :

This is the bias that where two or more similar events takes placeand the individuals thinks that they are highly co-related with each otherwhich also confuses to the individuals. But in reality they aren’t connected toeach other. Such a bias in behavioural finance is referred to as RepresentativeBias.

§ Framing Bias:

This is the bias where an individual makes the decisions based onhow the information presented even opposing the facts itself. If the same factsare presented in two different manners then to different decisions are made bythe same individual. Such a bias is referred as Framing Bias.

Approaches in Behavioural Finance for Decision Making

Different approaches recommended inBehavioural Finance for decision making

The bias that take places is because of the of the reflexiveapproach of the investors which means the more the decisions are based on thereflexive approach the more the chances of the biases. While if the investorsfollows reflective approach more then, the chances of bias eventually comesdown because of more rational decisions.