Behavioral finance explores the influence of psychology and human behavior on decision-making in the financial realm. Often, investors and business professionals make what are perceived as rash or ill-advised financial decisions, and behavioral finance is the field of study that attempts to explain why certain decisions are made. The field studies how human behavior influences financial decisions and focuses on how behavior affects the decision-making process.
The Differences Between Standard Finance and Behavioral Finance
In order to better understand behavioral finance, a brief overview of its counterpart, standard finance, is helpful. Standard finance — also known as traditional finance — assumes that people make financial decisions based on data, risk aversion and sound analysis. Standard finance assumes human beings act logically when it comes to financial decision-making.
Standard finance is built upon the following assumptions: People design their portfolios to reduce risk while maximizing return. Markets provide an efficient way to invest, and most people seek to manage the inherent risk.
Behavioral finance, on the other hand, incorporates cognitive psychology, which suggests that, sometimes, people disregard facts and numbers to make financial decisions on a whim or based on seemingly irrational thought processes. The study of behavioral finance as a part of the online MBA with a concentration in Financial Services seeks to alert students to behaviors that could impact financial decision-making and help students find ways to address these behaviors in the business realm.
Behavioral Biases as They Relate to Behavioral Finance
Behavioral finance accounts for the biases that inform financial decision-making. These biases fall into two categories: cognitive and emotional.
Cognitive Bias – Cognitive bias refers to a concept that is generally accepted as true even in the absence of evidence to back it up. One example of cognitive bias is the Bandwagon Effect. Following the crowd for the sake of following, rather than doing objective research, is an example of this type of bias. Status-quo bias is the resistance to change, which can affect all areas of life including business and financial decision-making. Even if a company is failing and sweeping financial changes are needed to protect the business, decision-makers might balk for fear of change.
Emotional Bias – Behavioral finance also covers the concept of emotional bias, which refers to a tendency to base decisions on emotion rather than fact. Making business decisions based on past experience rather than the current facts is an example of emotional bias. For instance, a CFO might decide not to extend resources for Research and Development (R&D) because the last project cost the company a substantial amount of money. The CFO is basing the decision on a past occurrence rather than the current environment.
Another type of emotional bias is the overconfidence bias. A person might assume a certain edge or understanding of financial markets based on a history of positive outcomes. Again, overconfidence bias is not based on fact.
When people make financial decisions in the business world, irrational behavior can have a negative impact on the companies or people involved. Understanding how biases influence financial decision-making underpins the study of behavioral finance. Being aware of these biases enables business professionals to know the pitfalls to avoid for sound financial decision-making.
Learn more about the UNC Pembroke MBA with a Concentration in Financial Services online program.
Sources:
ASPPA: What Is Behavioral Finance – And Why Do We Need It?
CFA Institute Research Foundation: Behavioral Finance – Core Principles and Practical Applications
CFA Institute: Behavioral Finance – Theories and Evidence
CFA Institute: Behavioral Finance Versus Standard Finance
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