Behavioural Finance-Related Mistakes Can Be Detrimental To An Individual's Financial Well-Being
Too many choices can lead to information overload and therefore decision paralysis
May 29, 2017 / 09:01 AM IST
What is behavioural finance?
Traditional finance theory assumed that investors are well-informed, careful and rational when making financial decisions. However, in reality humans are emotional beings and beautifully irrational, especially in long term activities such as investing. Behavioural finance takes into account research from psychology and empirical evidence to develop an understanding of financial decision making. Below are five common behavioural finance-related mistakes that most us make when investing:
Optimism bias: Behavioral research indicates that investors are overconfident with respect to making gains and oversensitive to making losses. There is also a tendency for individuals to place too much confidence in their own opinions & investment decisions, ignoring the real and alternative possibilities of their decisions. Investors who are overconfident tend to buy and less investors more often, which actually leads to lower returns compared to a simple buy and hold strategy.
Loss aversion: Investors are more sensitive to loss than to gains. In fact research indicates that people give twice as much weightage to losses than to gains. This gets reflected in multiple ways. People may invest for the long term but they keep reviewing their portfolio in the short term. And if there are losses in the short term, investors tend to deviate from a long term strategy and exit their investments.
Choice paralysis: Intuitively the more choices we have the better it is. However, too many choices can lead to information overload and therefore decision paralysis. This is most prevalent when we have multiple choices in areas where we are not comfortable - for e.g. investing for the common man. If given a choice to select between multiple mutual funds, research shows that participation decreases as the number of fund options increase.
Mental accounting: Our psychological self keeps different 'mental accounts' based on our life goals. For eg retirement or children's education or vacation next year. Our risk tolerance for each account varies depending on the underlying goal. However, in reality most of us treat our investments as a single portfolio and display all the above biases on the same portfolio. Once we approach investing from a Goal-based framework, we replicate the mental accounts in our investments and able to benefit from the different risk and reward opportunities for each goal.
For eg. for a vacation next year I would invest in safer debt mutual funds but for my retirement in 30 years I would be willing to take risk and invest into equity mutual funds for higher returns. If I treated my entire portfolio as a single pool, I would exhibit the various biases and either avoid taking risk at all or exit my investments at the first sign of risk.
Inertia & Regret Avoidance: Inertia and the human desire to avoid regret often act as a barrier to effective financial planning. For eg. if an investor wants to start investing but lacks certainty about the merits of the action, the most convenient path is to wait and see. This tendency to procrastinate dominates financial decision making in most people. The way to overcome this bias is to take a disciplined approach or 'commitment devices' - a commitment to regular monthly savings or SIPs - this can help people overcome inertia and meet their financial goals.Author is Co-founder, MintWalk