Investment Decisions and Behavioral Finance (2024)

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Investment Decisions and Behavioral Finance? ›

At its core, behavioral finance combines principles from psychology and economics to study how people make financial decisions. Traditional economic theory often assumes that individuals are perfectly rational and make decisions solely based on information and logic.

At its core, behavioral finance combines principles from psychology and economics to study how people make financial decisions. Traditional economic theory often assumes that individuals are perfectly rational and make decisions solely based on information and logic.

Understanding Behavioral Finance:

Behavioral finance is a discipline that combines principles from psychology and economics to explain how individuals make financial decisions. It recognizes that humans are not always perfectly rational and often make decisions based on cognitive biases and emotional responses.

Key Points. The primary goal of both investment and financing decisions is to maximize shareholder value. Investment decisions revolve around how to best allocate capital to maximize their value. Financing decisions revolve around how to pay for investments and expenses.

And yet, there is no dearth of investors making irrational decisions. Clearly, something else is at play here – cognitive bias and limits to arbitrage. These are the two pillars of behavioural finance.

It's an economic theory that explains often irrational financial behavior, such as overspending on credit cards or panic selling during a market downturn. People often make financial decisions based on emotions rather than rationality. Behavioral finance uses financial psychology to analyze investors' actions.

Investors tend to hold onto a belief and then apply it as a subjective reference point for making future judgments. People often base their decisions on the first source of information to which they are exposed (such as an initial purchase price of a stock) and have difficulty adjusting their views to new information.

Decision theory is the study of a person or agents' choices. It helps us understand the choices professionals, consumers, or even voters make when coming to a decision. There are two branches of decision theory – Normative Decision Theory and Optimal Decision Theory.

What is more important between financing and investment decision? ›

Investment Decisions

These decisions are considered more important than financing and dividend decisions. Here, the decision is taken regarding how investment should occur in different asset classes and which ones to avoid. It also involves whether to go for short term or long term assets.

An investment decision-making process helps you decide how much to invest in equity, bonds, real estate, gold, etc. It provides a customised strategy for asset allocation, diversification, risk and portfolio management. For an effective investment process, you must assess: Your investment goals.

An investment decision could involve purchasing new equipment, investing in research and development, buying new property, or expanding into new markets. These decisions often have long-term implications and are influenced by a multitude of factors.

So, what is behavioral finance? It's an economic theory that explains often irrational financial behavior, such as overspending on credit cards or panic selling during a market downturn. People often make financial decisions based on emotions rather than rationality.

Now that you have been familiarised with the basic concept of behavioural finance, let me introduce you to the four major themes of behavioural finance: over-confidence, financial cognitive dissonance, regret theory and prospect theory.

Traditional finance theories assume investors are rational and make decisions based on all available information. However, behavioural finance acknowledges that investors can be influenced by emotions and cognitive biases.