Why do you make irrational financial decisions?

Behavioral finance is the study of the effects of psychology on investors while taking financial decisions.

There are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable ways or contrary to conventional finance theories.

Our day to day lives are full of such behaviours. A common example of such decision making is credit cards vs paper money. For the same amount of payment, more pain is experienced when one has to shell out cash. Another example of irrational financial behaviour is buying lottery tickets with a one in a million chance of winning. Behavioural finance seeks to combine behavioural and cognitive psychological theories with conventional economics and finance to provide explanations as to why people make irrational financial decisions.

Following are the finance behavioural concepts:

Herd behaviour: When sheep herd, they move together at the same time. Usually, one or two leaders start, then momentum builds as more and more join until a large group is formed, all heading in the same direction. A similar idea holds true when investors follow the herd. The investors follow others rushing to buy or sell shares, debts, or any other investment. However, simply going with the herd is not likely to be a well-thought investment strategy as the followers can end up paying the price.

Anchoring: When formulating a financial decision or prediction, you have to start somewhere. The initial price or the number you pick turns out to have an enormous influence on your financial conclusion. For example, we walk into a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know that we can buy the car for that amount, and we start the process of seeking a better price.

Mental accounting: Mental accounting refers to the tendency for people to separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. According to the theory, individuals assign different functions to each asset group, which has an often irrational effect on their consumption decisions and other behaviours.

Gambler’s fallacy: In the gambler’s fallacy, an individual erroneously believes that the onset of certain random events is less likely to happen, following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. For instance, consider a series of coin flips that have landed with the ‘heads’ side up. Under the gambler’s fallacy, a person might predict that the next coin flip is more likely to land with the ‘tails’ side up.

Prospect theory: According to the theory, an average individual is more loss-sensitive. Losses have more emotional impact than an equivalent amount of gains. For instance, if you are gaining Rs 50 or Rs 100 and losing Rs 50, then both should have the same utility as in both cases, the net gain is Rs 50. However, despite the fact that you still end up with Rs 50 gain, in either case, most people view a single gain of Rs 50 as more favourable than gaining Rs 100 and losing Rs 50.