Researchers and academicians are increasingly accepting the transition of humans from being Homo Economicus to Homo Sapiens stating that human beings are not completely rational but that their rationality is bounded. Humans are normal as they have feelings and emotions along with logic and reasoning. These emotions and feelings give rise to heuristics or biases in their day to life in general and investment decision making in particular. These deviations from rationality arise due to limitation of time, information or of cognitive abilities of individual investors. As a result, investment choice becomes largely influenced by a number of factors both external and internal that limit the rational investment decision making ability of investors.
Behavioral finance is thus a blend of finance and psychology to understand why investors experience bounded rationality (biases) and its effect on the individual decision making at the micro level and the market behavior at the macro level. The relevance in finance and investment is even more as individuals have limited financial resources and irrational decisions can lead to poor investment strategies which in turn will result in sub optimal utilisation of resources. Many investors have burnt their fingers in the market on account of these impeding factors.
The major biases identified include: Overconfidence, Illusion of Control, Representativeness, Mental Accounting, Herding, Confirmation, Loss Aversion, Conservatism and Anchoring to name a few. But these biases do not work in isolation. The demographics of an investor, his experience in the market and other external factors play a significant role in influencing these biases.
Dr. Bindya Kohli