What is Behavioural Finance? Key Biases that Affect Investor Decisions

Understanding Behavioural Finance

Behavioural finance helps us understand why people sometimes make emotional or illogical choices with their money. Traditional finance says that everyone makes smart, logical decisions and that markets always work fairly. But in real life, things don’t work that way.

People often let their feelings guide their actions. They get scared by bad news, copy what others are doing, or only invest in things they already know. Behavioural finance studies this human side of money and shows how emotions and habits can lead to mistakes.

In India, many new investors join the stock market every year. If they understand these emotional habits, they can make smarter decisions, stay calm during ups and downs, and avoid losing money because of fear or greed.

Traditional vs Behavioural Finance

The two schools of thought differ sharply in how they view investors and markets. The table below shows the main distinctions:

Behavioural finance challenges the idea that financial decisions are purely logical. It brings psychology into economics and helps explain market anomalies such as sudden crashes or bubbles.

Main Concepts in Behavioural Finance

Behavioural finance is built on a few important ideas that explain how people think about money:

    • Mental Accounting – People tend to divide their money into mental “buckets.” For instance, they might treat salary, bonuses, or investments differently even though all are part of their total wealth.

    • Herd Behaviour – Investors often follow the crowd, especially in bull or bear markets. When others buy, they buy. When others panic, they sell.

    • Emotional Gap – Decisions made under stress, fear, or excitement often go wrong. Emotions can cloud judgment and push investors away from rational thinking.

    • Anchoring – Many investors fix their expectations based on one reference point. For example, they may refuse to sell a stock because they are anchored to its purchase price.

    • Self-Attribution – People credit success to their skills but blame failures on bad luck. This overconfidence can lead to taking unnecessary risks.

Key Biases That Influence Investor Decisions

1. Overconfidence Bias

Many investors believe they know more than they actually do. This confidence often leads to excessive trading or risky bets. In India’s fast-growing market, overconfidence can make investors ignore research or diversify poorly.

2. Confirmation Bias

Investors seek information that supports what they already believe. They read reports that confirm their views and ignore data that challenges them. This bias stops them from seeing the full picture.

3. Anchoring Bias

Anchoring happens when investors rely too heavily on an initial piece of information. For example, if a stock was once ₹500, they might still value it near that mark even when its fundamentals have changed.

4. Loss Aversion

People fear losing money more than they enjoy making it. This fear leads investors to hold on to losing investments hoping they will recover, or sell winning ones too early. The pain of loss often outweighs the pleasure of gain.

5. Herding Mentality

Following the crowd is a common behaviour in the stock market. When everyone invests in the same trending stock, prices rise beyond reasonable value. This herd behaviour has caused several market bubbles worldwide.

6. Recency Bias

Recent events influence future expectations. If the market has done well for a few months, investors assume it will keep rising. This short-term thinking can lead to poor timing and overconfidence.

7. Framing Bias

How information is presented changes how people react to it. If a mutual fund advertises a “90% success rate,” it sounds better than saying “10% loss probability,” even though both mean the same.

8. Familiarity Bias

Investors prefer to invest in companies or products they know. While this feels safe, it reduces diversification. For instance, someone might only buy Indian stocks, avoiding global opportunities.

9. Self-Deception Bias

Sometimes investors fool themselves into thinking they have answers to every question. They ignore facts that challenge their beliefs and also overestimate their ability to predict outcomes.

10. Hindsight Bias

After a market event, investors often believe they “knew it all along.” This false sense of predictability makes them overconfident and blinds them to real risks that await.

Why These Biases Matter

Behavioural biases can have a big impact on how much money investors make. They often cause people to buy when prices are high and sell when prices are low, which is the opposite of what smart investors do. Understanding these biases helps people stay calm and make wiser choices.

In India, many small investors react too quickly to news or what they see on social media. This emotional way of trading can lead to losses that could have been avoided. When investors understand their own habits and emotions, they can make steadier and more successful decisions.

How to Overcome Behavioural Biases

1. Focus on the Process

A disciplined process helps investors stay consistent. Setting a clear strategy for buying, selling, and reviewing investments reduces the impact of emotions. Logical steps make decision-making more reflective rather than impulsive.

2. Prepare and Plan

Planning ahead helps avoid hasty decisions. Having a pre-decided strategy for different market conditions can reduce panic during market downturns.

3. Diversify Investments

Diversification protects against overconfidence and familiarity bias. Spreading investment across sectors, asset classes, and regions lowers overall risk.

4. Seek Professional Advice

Sometimes, a second opinion brings perspective. Financial advisors or planners can help identify personal biases and design balanced portfolios.

5. Learn and Review Regularly

Continuous learning builds self-awareness. Reviewing past decisions helps spot patterns of bias and correct them before they repeat.

Conclusion

Behavioural finance is about how our thoughts and feelings affect the way we use and invest money. It knows that people don’t always make perfect choices. We can be influenced by our emotions, habits, or by what others say. When we understand this, we can make smarter decisions and stay in control of our money.

In India, where the stock market goes up and down quickly, learning about behavioural finance is very useful. When people understand their feelings and avoid common mistakes, they can make calm and sensible choices instead of acting out of fear or excitement.

In the end, good investing isn’t about always guessing the market correctly. It’s about knowing yourself, being patient, and making wise decisions even when your emotions try to take control.