Ever wondered how the stock market functions? It is not always the company performance, global scenarios, or for that matter a simple demand-supply that impacts the trend in the market, one of the biggest factors are psychological influences, biases, and sentiments of investors and practitioners which is termed as Behavioral finance..
What is the Meaning of Behavioral Finance?
Behavioral Finance is about the study of how psychology and beliefs affect the decision making of investors and Financial Analysts. Investors and financial analysts both are major influencing factors when it comes to setting a trend in financial markets. Behavioral finance also explains how influences and biases or any sentiment can lead to market irregularities especially in the stock market which can lead to severe rise and fall in stock prices.
Example: How the news of a potential COVID 19 vaccine developed by “Glen mark Pharmaceuticals in the name of Fabiflu” led to a tremendous surge in the stock prices of the company as the investors and analysts have a positive sentiment for the company.
Basic Understanding of Behavioral Finance
As we now understand what is Behavioral finance. Let us now focus more on how exactly behavioral finance works across various sectors and Industries.
One of the basic assumptions of Behavioral finance is that we as investors are not rational human beings and are also not self-controlled. Our purpose is to understand why we as investors make certain financial assumptions and how based on those assumptions, decisions made impact the markets. The most important aspect of Behavioral finance is “Biases”.
Biases can happen for various reasons.
Example: We as investors always tend to focus more on our predetermined notions about a certain sector, industry, or the market in totality rather than following market analysis or readily available reliable sources of information to conclude. This was very clearly evident in case of purchase of N95 masks in India when it was rumoured that it helps protect against COVID 19 where in the real world it is as per the article from WHO stating that the mask is not secure in protection against the pandemic.
Traditional Financial Theory vs. Behavioral Finance Theory
The traditional financial theory assumes that we as an investor use relevant data, knowledge, and skills to process information to arrive at an optimal choice in a rational and unemotional way.
In traditional financial theory:
- Investors have perfect self-control
- Investors are rational decision-makers
- Markets function based on rational decisions and non-biased sentiments
- Investors are only concerned about financial characteristics and performance parameters of the markets
While in behavioral finance theory:
- Biases influence the decision-making ability of the investors
- Investors are not rational decision makers
- Market trends are greatly dependent on the emotional sentiments and psychological mind-set of the investors and financial experts
- Investors have certain limitations concerning their self-control.
