Behavioural Finance

People (you and me) frequently behave irrationally. With more and more individuals participating in the economy through consumerism and through investing, it is crucial to know what ‘ticks’ people.

Behavioural Finance is all about trying to understand biases in human behaviour, when it comes to money. Basically, the idea is to look for the reasons that people make the money choices they do. Behavioural Finances seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational decisions.

Consider how many people purchase lottery tickets, even though the probability of hitting a jackpot is infinitesimal.

KEY CONCEPTS OF BEHAVIOURAL FINANCE

Mental Accounting: You do not instinctively spend your money, without thinking for even once. You divide up money, designate money for certain purpose. You make a mental map to spend your money.

Herd Behaviour: This is quite common, as the larger group does something like buy a ‘hot’ stock, individuals tend to follow suit. If you’ve got money, you’ll want to know what the fuss is about! (Breaking the herd mentality is beneficial for your finance)

Anchoring: This happens to the brand conscious crowd. For example, a subway burger costs around 300 bucks which has “best” tag attached to it. Normally a burger would come under 50 bucks,but since you are now anchored to the idea of the “best” costing 300, you don’t want to spend “only” 50 bucks. Instead you compromise for a 200 Rs. burger. You spent more than what you wanted, because of that anchor.

Conformational Bias: People tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationalizing the rest. This type of selective thinking is often referred to as conformational bias. For e.g. An investor is more likely to invest in an idea that supports his/her original idea.

Denomination Effect: People tend to overhaul bigger bills. Although five Rs. 100 notes is equivalent to a Rs. 500 note, but there’s a psychological cost associated with spending a Rs. 500 note that’s not there with spending smaller notes. It’s easier to part with five of those 100 rupee notes than with a single precious 500 rupee note in your pocket.

BOTTOMLINE: Carry bigger notes as a form of self-control and restrain in order to spend less money.

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