Understanding human behavior in financial markets

We often tend to lean on any field of study with certain presets which are considered as standards in the subject. The study of finance, for example, is often seen as a game of calculating and drawing graphs. We tend to ignore the involvement of human psychology at different levels and this leaves some gaps in our assessment and understanding of the subject. It is for a very simple reason that finance, as technical as it is, is carried out and managed by humans and above all for their benefit. As such, studying finance without understanding human behavior or psychology will render our understanding of finance incomplete.

The goal of behavioral finance is to understand why people make certain financial decisions and how those decisions affect financial markets or systems. In behavioral finance, participants are assumed to be influenced by many personal and environmental components, rather than being perfectly rational and self-controlled.

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If one were to trace the growth of a financial magnate, one would find oneself studying a series of decisions he made over time. A closer look can show us that it’s often these (seemingly small) decisions that end up defining this tycoon’s journey and setting him apart from the mainstream crowd.

What made these decisions good or bad, ingenious or unthinkable, can be understood by what prompted them, what obstacles hindered them, and how effectively they were addressed.

As deep as we can dig into the financial details and implications of said decisions, it will always all come down to some unique human factors that dictated them. This means that the study of finance can possibly be incomplete without the study of decision-making, and more broadly, without the study of human behavior itself.

An important point of reference for understanding this is that of Daniel Kahneman and Amos Tversky.Prospect Theory: A Study of Decision Making Under Risk’. Investors evaluate outcomes against a subjective benchmark, such as a stock’s purchase price, rather than calculating the universe of possible outcomes and picking the best, as the paper points out. Additionally, investors are loss averse, meaning they are willing to take more risk in the face of losses, but are risk averse when it comes to protecting their gains. This was an important aspect that had not been considered before that time. The elements of human considerations and apprehension have been taken into account.

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So what remains important in behavioral finance is to consider all aspects of human behavior that will ultimately affect the end result of financial events. This can include our biases, our ideology, our mindset, our environment, our upbringing, rather anything that can end up affecting our choices.

Our choices, while often well-intentioned, are not necessarily reasonable. We can make a decision based simply on our feelings. Such a step could lead to a slew of bad investments and resource allocations, as well as erroneous risk estimates, etc.

There are times in our financial lives when we make decisions “unknowingly,” that is, without being aware of the biases that may be pushing us in that direction. However, simply labeling or acknowledging these biases is unlikely to help us in the long run. Instead, we should invest in our financial future with something that is certain to produce higher returns: a better understanding of ourselves.

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The point here, according to Seton Hall University professor Jennifer Itzkowitz, is not that individuals are irrational, but that their irrationality is predictable.

This predictability can be seen in behaviors such as allocating money to mental compartments and remembering them (so that they betray us later), being drawn into investment programs by softer factors such as qualities demographics of the company’s pioneers, anxious investing to “avoid losses” rather than investing to “seek gains”, and more.

That’s why academic courses, which seek to uncover the origins of our unconscious biases while imparting knowledge about investing, trading, portfolio management, and other topics, deserve our support. To avoid falling victim to our old habits of biased interaction with the market, we must first understand what these patterns are, how they came about, and what motivates us to keep them.

Dr. Sanjeev P Sahni is a renowned psychologist and author on psychological issues. He currently heads the Jindal Institute of Behavioral Sciences (JIBS)