What are behavioural biases in investing and finance?

Investing and finance, as objective as they may seem, are often deeply influenced by human psychology. These psychological tendencies, known as behavioural biases, can drive investors to make decisions that are not always rational, leading to market anomalies such as price bubbles or crashes. Understanding the behavioural finance meaning is crucial for anyone looking to invest in share market online or use a trading platform in India effectively.

In this blog, we’ll explore the nature of behavioural finance, its key concepts, and common biases that affect investment decisions.

What is behavioural finance, and why is it important?

Behavioural finance is a subfield of economics that examines how psychological factors influence the financial behaviours of individuals and markets. Traditional finance assumes that investors are rational, have full information, and always make decisions that maximise their wealth. However, behavioural finance reveals that people are often influenced by emotions, cognitive errors, and biases when making financial decisions.

Understanding the nature of behavioural finance is essential because these biases can lead to poor investment choices, such as selling stocks during a market panic or holding onto losing investments in hopes of a recovery. By recognising and managing these biases, investors can improve their decision-making process.

What are the key biases in behavioural finance?

Several biases have been identified in the study of behavioural finance. Here are some of the most common ones:

1. Loss aversion – Why do investors fear losses more than they value gains?

One of the most well-known biases in behavioural finance is loss aversion. This bias refers to the tendency for individuals to prefer avoiding losses over acquiring gains. In practical terms, the pain of losing ₹1,000 feels much stronger than the pleasure of gaining the same amount.

This bias often leads investors to hold on to losing investments for too long, hoping for a recovery, while quickly selling winning investments to lock in gains. In the context of a trading platform in India, for instance, investors might refrain from selling a poorly performing stock, fearing the emotional impact of realising a loss.

2. Herd behaviour – Why do investors follow the crowd?

Humans are inherently social beings, and this behaviour spills over into the stock market. Herd behaviour occurs when individuals mimic the actions of a larger group, often without considering their own analysis or objectives. This can lead to speculative bubbles, where stock prices soar because everyone is buying, and crashes when the herd begins to sell.

For example, during periods of high market volatility, many investors rush to buy or sell shares based on the actions of others rather than carefully analysing the situation. This emotional decision-making often leads to poor outcomes.

3. Familiarity bias – Why do investors prefer what they know?

The familiarity bias refers to investors' tendency to favour investments they are familiar with, such as domestic companies or sectors. In India, this could mean investing in well-known blue-chip companies while avoiding newer or international stocks, which might offer better diversification or higher returns.

While familiarity can provide comfort, it often limits diversification, increasing the risk in an investor's portfolio. By sticking to what they know, investors may miss out on potential opportunities in unfamiliar markets or sectors.

4. Overconfidence bias – Can too much confidence hurt investment decisions?

Many investors suffer from overconfidence bias, where they overestimate their ability to predict market movements or choose winning stocks. This bias can lead to excessive trading, higher transaction costs, and, ultimately, lower returns.

For instance, an investor using a trading platform in India may believe they have superior insight into market trends, leading them to make frequent trades. However, this overconfidence can often result in poor timing and suboptimal investment outcomes.

5. Mental accounting – How do we treat money differently based on its source?

Mental accounting refers to the tendency for people to categorise money differently depending on its source or intended use. For example, an investor may treat their savings more conservatively than a bonus or a windfall. This bias can lead to irrational financial decisions, such as taking higher risks with "extra" money.

In the context of investing in the share market online, this could mean an investor might risk more on speculative trades while keeping their core investments conservative. Such compartmentalisation can prevent investors from seeing the bigger picture and making sound financial decisions.

How can understanding behavioural finance improve investment decisions?

By understanding the psychological biases outlined in behavioural finance, investors can become more aware of their own tendencies and make more rational decisions. This self-awareness can help them:

• Avoid the pitfalls of herd mentality during market booms or crashes.
• Make informed decisions rather than relying on emotional reactions.
• Build a diversified portfolio, mitigating the risks associated with familiarity bias.
• Trade less frequently, reducing the impact of overconfidence bias and lowering transaction costs.

Invest safelyBehavioural finance offers valuable insights into how investors’ psychological biases impact their financial decisions. Whether you are using a trading platform in India or looking to invest in share market online, understanding these biases can help you make better, more informed decisions. By recognising and addressing these biases, you can increase your chances of long-term success in the volatile world of investing.