Behavioral Finance and Its Impact on Investing

Behavioral Finance and Its Impact on Investing

During Tulip Mania in 1637, Dutch tulip bulbs were more expensive than houses. People continued to purchase them at such high prices because they believed tulips would keep rising indefinitely. However, the bubble burst when demand suddenly decreased, and contractors were left with worthless contracts for tulip bulbs, which left many financially ruined. This illustrates how emotions and cognitive biases drive our financial decisions when we ignore logic and introduces us to the concept of behavioral finance. Traditionally, it was believed that investors are always rational and logical and make informed decisions based on the data and information. However, behavioral finance questions this norm by saying that our emotions do influence our decisions and can even lead to irrational financial choices. 

Cognitive Vs. Emotional Bias

Behavioral Finance highlights two primary biases- cognitive bias and emotional bias. Cognitive bias comes when investors make decisions based on preconceived notions or flawed reasoning. For example, Confirmation bias makes investors rely on intuitions and not on logic, and often ignore contradictory views. ⁽¹⁾ Though these biases can be mitigated through education and exposure to diverse perspectives, leading to structured decision-making. Some of these biases are-  

1.     Confirmation Bias

If investors believe that a particular stock is a winner, they will eagerly focus on only positive news related to that and ignore negative information. This is what happens in confirmation bias: we ignore negative points and only see the positive side as far as it suits our beliefs. It sometimes leads to holding onto bad investments for too long simply because it “feels right”. However, to mitigate this, investors should seek diverse opinions and rely on the information available.

2.     Anchoring Effect

Imagine stock trading at Rs. 2,000 a year ago, but now it is at Rs. 1,000. Investors might buy the stock, hoping that it will reach its initial price soon, ignoring the factors that could have led to stock deterioration. This is the anchoring effect, where people rely on initial information like stock prices in the past. This can lead to poor investment choices. Investors should compare multiple data points and analyze current market conditions.  

3.     Mental accounting

Ever seen people spending their salary and income earned from any other source, like rent, differently? That’s mental accounting, in which people treat income from different sources differently. For example, an investor might take more risk with money earned from the lottery rather than investing it cautiously. This usually leads to reckless investments and unnecessary losses. Investors should make decisions based on their overall portfolios to mitigate this bias.

4.     Gambler’s Fallacy

Imagine flipping a coin and getting 3 heads straight in a row, many will believe that now also heads will show up, without any proper logic. This is the Gambler’s fallacy, where our future decisions are highly influenced by past events. In investing, traders believe that if the price of a stock has risen over the past 3 years, it is now bound to fall or vice versa. Relying on this concept makes one take poor financial decisions. According to academia,” The gambler's fallacy is significantly responsible for the fact that the optimal structure of a portfolio is considered in only 37.7% of all choices made by an investor.”⁽²⁾ This means that due to Gambler’s Fallacy only 37.7% make optimal portfolio structure, and majority of investors fail to diversify or allocate resources effectively. To mitigate this bias, investors accept that the market is a dynamic place and should rely on statistical data rather than past trends.

5.     Status Quo Bias

People prefer things to stay the same and are reluctant to adopt any change that might be beneficial. In Status Quo Bias, investors want to stick to their familiar investing strategy and avoid exploring new opportunities or better alternatives. This bias can prevent diversification, and one can miss opportunities that could lead to growth. However, this can be mitigated by stepping out of comfort zones and making decisions rationally and defaulting to familiarity. Thus, investors should regularly review their portfolios and be open to changes depending on what the market is demanding.

6.     Loss Aversion

Decision Lab states, “Loss aversion is a cognitive bias where the emotional impact of a loss is felt more intensely than the joy of an equivalent gain.” ⁽³⁾ Let’s understand this with an example: Investors panic and sell their winning stock quickly out of fear of losing money, but keep their losing stocks, hoping they will recover, even if it increases their losses.  Thus, we feel more pain while in loss than we feel joy while gaining. To mitigate this, they should define their exit strategy priorly to and focus on long-term goals.

Emotional Biases

On the other hand, emotional biases come from feelings rather than preconceived notions. It is deeply affected by human emotions, where investors let their fear, greed, and overconfidence influence their decisions. For example, in Herd Mentality, investors invest on some stocks just because everyone else is talking about it. Unlike cognitive biases, emotional biases are harder to correct because these biases are part of human personality. Some of the emotional biases are-

1.     Herd Mentality
Sometimes we buy stock just because everyone around us is talking about it. That’s herd mentality. Investors follow the crowd and take similar decisions as every other investor, thinking that if everyone is doing it, then it must be the right move. Herd mentality often creates a bubble that soon bursts. In 2017, the price of bitcoin skyrocketed as many investors started gaining interest in it, hoping that it would give them massive gains. But as soon as the interest faded, bitcoin prices crashed. That’s what happens in herd mentality: it starts with hype, but soon the bubble bursts, leaving many with empty pockets. To counter this, investors should conduct research and take data-driven decisions and avoid impulsive trading.

2.     Endowment Bias
Investors believe that their assets are worth more than they are. This makes them reluctant to sell, and they keep assets for too long, not evaluating their actual market potential. ⁽¹⁾ To overcome this, they should evaluate their assets from time to time and compare them with alternative opportunities.

3.     Overconfidence Bias
Investors usually believe that they have superior knowledge and end up taking excessive risks. They ignore diversification and underestimate market dynamics. James Montier once surveyed 300 fund managers, out of which 74% believed that they were above average when it comes to investing, and only 26% believed themselves to be average. ⁽⁴⁾ Thus, nobody even believed that they were below average or accepted the scope for learning. Investors take diverse opinions and review their past mistakes and rely on expert analysis rather than intuition.

4.     Availability Bias
Imagine you hear a piece of news about a stock skyrocketing overnight, you will pour money into similar stocks, ignoring the actual data, and hoping that these stocks will grow too. This is availability bias, where, based on past experiences, we make decisions that can lead us to poor decisions. To mitigate this, investors should take time to research historical data and seek diverse information to balance the perspective.

5.     Regret Aversion
Do we ever buy something expensive not because we truly need it, but because we fear that we might regret not buying it in the future, as it’s an exclusive deal? This is regret aversion in which we make decisions impulsively and don’t weigh risks and benefits, just to avoid future regrets. While it can benefit people by avoiding future regret, but sometimes it can also lead to irrational decisions. To mitigate this, investors can focus on long-term benefits, practicing self-awareness, and making decisions weighing pros and cons.

Behavioral Finance Vs. Traditional Finance

If investors are always rational, then why do market crashes occur? Why do investors sell in panic during downturns? The answer lies in the difference between traditional finance and behavioral finance. It’s a battle between logic and emotions.

Traditional Finance holds that investors are always rational and have logic behind their decisions. The corporate Finance Institute describes efficient market hypothesis (EHM) as, “As there are always many both buyers and sellers in the market, price movements always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at their current fair market value.” ⁽⁵⁾ This suggests that markets are always operating at optimum efficiency, and asset prices always reflect all the information known.

On the other hand, behavioral finance challenges the traditional finance idea that investors are always rational and logical. Instead, it argues that their decisions are often driven by emotions, biases, and psychological factors, which frequently lead to irrational behaviour. For example, in the 1990s and early 2000s, there was a wave of technology. Investors were investing in companies having “dot com” in their names. Many of these companies had little revenue but were simply valued at billions because they had “.com” in their name. But most of these companies lacked sustainable models, and in October 2002, stock prices fell by 78%. ⁽⁶⁾ This market crash wiped out billions in wealth just because the decision made was only based on overconfidence and herd mentality.

Thus, traditional finance discusses how the market is always rational and behaves in an anticipatory manner, while behavioral finance discusses the market dynamics and why it doesn’t behave as expected. 

How does behavioral finance impact investing?

These biases and psychological factors are the hidden forces that shape our investment decisions. Whether in the stock market, retirement planning, or personal finance, these biases are crucial in shaping our decisions. Let's see how-

How biases drive stock market trends
Usually, these biases drive the market and create market booms, crashes, and dynamic movements.
2008 Financial crisis- Investors believed that real estate prices would never fall, leading to excessive risk-taking. The result of this overconfidence bias was the worldwide crash.

How biases influence investment strategies
Biases can also shape your portfolio decisions, trading habits, and risk-taking.
Biases like loss aversion and the anchoring effect can influence our investment strategies. Investors either relying on initial information and taking future actions accordingly, or keeping a losing stock for too long, affect the investor's portfolio.

How biases impact personal financing
Biases not only affect investors but also our personal financial decisions, like how people save, spend, and plan.
People spend windfall gains like lottery or bonuses very recklessly, or some take excessive risks or avoid investments that could yield better returns, following the herd mentality.

Understanding these biases can help investors in making more sensible and conscious decisions and can help avoid costly mistakes. But investors usually fall prey to these biases, leading to irrational decisions. But some strategies can make decisions more rational-

·       Diversification- Sometimes investors focus on few stocks out of overconfidence or herd mentality. So, diversification can mitigate this risk by investing across different asset classes like stocks, bonds or real estate.
For example, investors who diversified during dot- com bubble avoided major losses when the market crashed. ⁽⁷⁾

·       Rebalancing Portfolios- Investors sometimes make decisions emotionally, leading to overexposure to certain assets. Regular rebalancing should be done to stay aligned with financial goals by setting a target asset allocation or by adjusting holdings periodically to maintain balance. ⁽⁸⁾

·       Recognizing Biases- The first step to overcome anything is to accept it. Investors should seek diverse viewpoints before deciding and conduct periodic emotional checks before making trades.
For example, Warren Buffett’s famous quote, “ Be fearful when others are greedy and greedy when others are fearful”. This statement talks about Warren Buffett’s consideration before deciding, as he avoids herd mentality and focuses on fundamentals rather than market hype. ⁽⁶⁾ By implementing these strategies, investors can reduce emotional decision-making, minimize risk, and build a more resilient portfolio.

Conclusion

Behavioral Finance has transformed the way investors approach financial decisions. It highlights how biases like loss aversion, herd mentality, and overconfidence can lead to irrational decisions. Acknowledging these biases helps investors in making more rational and informed decisions, and investors can avoid common pitfalls, build strong portfolios, and make rational decisions. Thus, it is about combining rational analysis with a deep understanding of human psychology.

Notes:

1.      The Decision Lab, what is loss aversion?

2.      Corporate Finance Institute, Efficient Market Hypotheses

3.      Wikipedia, Dot-com bubble, April 29, 2025

4.      Bajaj FinServ, what is the impact of behavioral biases on investment decisions and strategies, March 1, 2024

5.      Trustnet, Strategies for overcoming investment biases, November 28,2024

6.      Trustnet, Warren Buffet’s contrarian investing: Going against the herd, May 9,2025

7.      Wall Street Mojo, Behavioral Finance

8.      Finance Calculators, Introduction to Behavioral Finance: Decoding the Psychology of Financial Decision Making, September 11, 2023