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Insights provided by behavioural finance for personal finance strategy creation

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Abstract

Behavioural finance’s potential to impact personal finance planning has long been a topic of substantial debate.This essay examines the correlation of the field of behavioural finance to the formation of personal strategy with the goal of illustrating the strengths and weaknesses of the approach. The results of this study illustrate the close bond that lies between the psychological state and the investment patterns undertaken by active investors.

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This research will be of interest to any person studying the impact of behavioural finance on personal strategy.

Introduction

The field of behavioural finance is argued to have a considerable impact on personal financial planning, personal finance and strategy formation (Banerjee, 2011). This area is cited by many to have the capacity to dictate the plan that a person might choose to employ during the course of forming a personal investment strategy. Effective planning is central to the identification and subsequent illustration of systemic and habitual manners that can be both positive and detrimental in the course of creating the best price and return on investment (Baker et al, 2010). Beginning with a clear examination of impact, this essay sets out to define and provide a demonstration of the impact that behavioural finance can have on the entirety of a personal financial strategy with the intent of providing the means to avoid future mistakes.

Behavioural Finance

Benartzi (2010) defines the area of behavioural finance as the use of psychological based insights to create economic strategy. This approach demonstrates the potential impact that day to day emotions and basic intuition can have on a personal financial situation. In many cases, the use of emotion to operate investment strategy has resulted in a significant failure or systematic issues that continuously plague the investor (Benartzi, 2010). This suggests that some emotion-based investing is either ill-timed or ill-conceived and therefore faulty and liable to lead to significant losses in the short- to mid-term. Conversely, many argue that intuition, based on effective knowledge, has the capacity to lift an investor above the majority and provide a method of obtaining great investment gains (Benartzi, 2010). In contrast to emotional investing, basing a strategy on an inherent skill or talent is suggested here to have the innate capability to achieve the end goal of base profit. However, the line between emotional or biased investment and undiluted intuition seems to be slight and extraordinarily slippery, leading directly to poor financial planning.

Meier (2010) illustrates the position that many mainstream investors can be identified as the classical or standard variant. This form of investor commonly assumes that they know what is in the best interest of their portfolio and it is well within their power to implement (Meier, 2010). This method of investment operates on the notion that rivalry between firms will maintain competition and therefore require minimal oversight, enhancing trust in the endeavour. However, this view is offset by the behavioural financial argument that contends that investors are often confused or misled, and despite the best intentions of many investors there is often significant lack of follow through during the strategy process (Meier, 2010). This suggests that psychology has direct and compelling impact on any formation of a personal investment plan and that often less than optimal decisions are made. Further expanding on this point is the practical issue of the need for regulation in a world often described as corrupt and morally bankrupt (Paramasivan et al, 2009). Taken together, the separation of mainstream theory from behavioural reality seems to lead many investors to incomplete assumptions and poor patterns of investment behaviour and financial planning.

McAuley (2009) illustrates the view that common decision making is based a concept referred to as heuristics or common sense rules of thumb. These approaches utilise the same capacity that humankind has employed to make day to day decisions for centuries (McAuley, 2009). However, many investors commonly use poor or mistaken data in their efforts to make a profitable investment in often volatile markets (Forbes, 2009). This concept supports that notion that there is the opportunity for investors to utilise an incorrect data model in order to create strategies, which in turn can lead to substantial losses and an eventual fundamental failure of strategy. Further expanding on this point is the creation of bias during the assessment process (McAuley, 2009). Bias is commonly defined as randomised departures from the rational process, although there is often a link to the rational base (Subrahmanyam, 2008). This suggests that some decision making is based on inherently poor material, which in turn is credited with leading the entire strategy to decline. With each loss there is a continual perpetuation of the bias cycle, with negative actions resulting in consistently negative consequences (Baker et al, 2011). Alongside this link to emotional investment patterns, there have been several forms of bias recognised and addressed during the process of personal fjnance formation and financial planning.

Insufficient adjustment is the inherent bias on the part of the investor to overlook the larger market picture and remain too conservative in their investment approach (McAuley, 2009).With this lack of confidence in the building strategy on the part of the investor, there is a very dim prospect for the personal financial planning efforts to make a significant gain. Further, this bias could in fact hold back an investor from reaching out to an emerging opportunity, which in turn can become a fatal habit. Conversely, the bias of overconfidence is credited with much of the investor losses over the course of the past recession and decade (McAuley, 2009). This bias has the inherent capacity to compel an investor to disregard sound advice or patterns in favour of other highly questionable actions (McAuley, 2009). This suggests overconfidence can easily overextend or compromise a working strategy.

Modern financial theory has been developed in order to explain and develop the area of behavioural finance (Debondt et al, 2010). Redhead (2008) points to the Prospect Theory as a key method of determining the context of an investor’s behaviour. This approach argues that there are three separate components that must be considered in regards to an investor’s behaviour (Redhead, 2008):

a) The perceived elements that are subject to bias. This identifies and illuminates the personal components that are tied to an investment decision.
b) Investors are far more concerned with immediate losses and gains as opposed to overall level of wealth.
c) Investors feel losses much more dearly than they do gains.

Each of these elements ties into the state of the investor’s emotional and psychological balance preceding their investment strategy, which in turn provides the means to assess and adapt a developing investment plan (Redhead, 2008).

Deaves et al (2005) contends that loss aversion is among the most powerful of the behavioural patterns expressed by anxious investors. In order to offset the concerns many potential market participants follow eight recommendations that have been found to have a direct impact on the formation and execution of a personal financial plan (Deaves et al, 2005):

1) Take a holistic view of the available assets and associated liabilities. There is and must always be room to adapt and adjust.

2) As much as possible allow for the maximum amount of affordable pay to be automatically invested within the client portfolio. This often takes the decision point away and offers a long term yield benefit.

3) Disregard the past actions and base investment decisions on future estimates of costs and benefits.

4) Take a long-term, as opposed to a short- to mid-term view of the investment portfolio.

5) Avoid any passing fad or quick trend promising a quick turnaround.

6) Past performance is no guarantee of future earnings.

7) Save as much as possible, as often as possible.

8) Stay the course.

This approach to behavioural finance suggests that utilising elements of theory to assist in the creation of proper strategy is actively engaging the psychological tendencies of the investors in order to capitalise on their inherent strengths as well as avoid their innate detriments. Yet, despite the efforts of some financial planners many common investment mistakes continue to take place no matter the system in place (Montier, 2007). A very common loss aversion tendency that is credited with the loss of many investors’ assets is the tendency to hold on to a losing stock for too long based on past performance or associated issues (Benartzi, 2010). This is based on the very real emotional base of pleasure seeking and pain aversion. If person sells a successful stock and gains a profit, pleasure is felt, thereby encouraging the investor (Benartizi, 2010). Conversely, letting a failing stock linger, and losing money is credited with very physical manifestations of pain, which in turn lead to poor decisions the state of personal finances and personal finance planning (Benartizi, 2010).

Risk aversion in behavioural finance has the potential to manifest in several different identities in the course of determining a personal financial strategy (Montier, 2007). This is a suggestion that the method that an investment is packaged and presented, or framed, has a direct bearing on the application or implementation of the proposal. Using tools including cash back incentives, or gifts, is a common method for inducing investors to overlook other data in favour of investing in the underlying company (McAuley, 2010). This suggests that a favourable set of circumstances to the investor have an impact on the manner and method of investment, prompting many advertisers and financial planners to readily target specific behaviour elements during their efforts to spur .

Hens et al (2008) argue that in many cases an investor has an expected utility of the associated investment that is unrealistic. Many leading financial strategists state unequivocally that no one human can be fully informed on any single investment (Pompian, 2006). This leads to the investor believing that they have more control than is present in the endeavour, which in turn leads to a diminished or detrimental return. Baker et al (2010) credits many of the investment decisions made by investors as based on the discounting of the future potential in favour of the quick and present, albeit smaller, rewards. This need for immediate satisfaction has a direct impact on the ability for a portfolio to make the most of the assets available.This suggests that successful personal planning will focus on the mid to long term investments with a clear determination to avoid any quick or offhand investment decisions. Baker et al (2010) extend the point of the need to avoid physical distraction by illustrating studies that connect the gastronomically centred portion of the brain to the segments related to the investment areas. This is an indication that habits that are common in the population, including over eating and poor diet, can be extended to the investment portfolio. Emerging methods including surveys, interviews and focus groups are allowing for the concept of behavioural finance to be incorporated into mainstream investing (Muradoglu et al, 2012). With clear success in defining and removing behavioural impediments, many investors are looking to this field of research for potential edges in determining future strategy.

Conclusion

Behavioural finance is argued to provide substantial impact on personal finance and personal planning and the results of this essay support that contention. Despite the desire for a black and white investment environment, there is no escaping the impact that inherent bias, shortcoming and basic human error play on the implementation of an effective investment scheme. The material presented illustrates the potential for personal bias based on such base elements as the food consumed prior to making decisions, yet, the process of identification has the potential to offset the negative and enhance the positive. Further, intuition has been credited with propelling many investors to success, yet, this is separate from the decision making process that allows for the creation of bias and the inclusion of errant material.

A clear benefit to the implementation of a personal financial strategy is knowledge of the elements that make up the field of behavioural finance, allowing the creation of an effective process to offset any negative pattern of investment behaviour. In the end, as with all manner of investments, it comes to discipline, skill, patience and the determination of the investor to not be swayed in the face of adversity but hold to the reality of any situation.

References

Baker, H. and Nofsinger, J. (2010). Behavioural finance. 1st ed. Hoboken, N.J.: Wiley.

Baker, M. and Wurgler, J. (2011). Behavioural corporate finance: Wiley.

Banerjee, A. (2011). Application of Behavioural Finance in Investment Decisions: An Overview. The Management Accountant, 46(10).

Benartzi, S. (2010). Behavioural Finance in Action. Allianz 1(1) p. 3-6.

Brigham, E. and Ehrhardt, M. (2005). Financial management. 1st ed. Mason, Ohio: Thomson/South-Western.

Deaves, R. and Charupat, N (2005). Behavioural Finance. Journal of Personal Finance 1(1). P. 48-53.

DeBondt, W., Forbes, W., Hamalainen, P. and Muradoglu, Y. (2010). What can behavioural finance teach us about finance?. Qualitative Research in Financial Markets, 2(1), pp.29–36.

Forbes, W. (2009). Behavioural finance. 1st ed. New York: Wiley.

Hens, T. and Bachmann, K. (2008). Behavioural finance for private banking. 1st ed. Chichester, England: John Wiley & Sons.

McAuley, I (2009). Understanding human behaviour in financial decision making. Centre for Policy Development 1(1). p. 1-5.

Meier, S. (2010). Insights from Behavioural Economics for Personal Finance. Behavioural Economics and Personal Finance 1(1). p. 1-3

Montier, J. (2007). Behavioural investing. 1st ed. Chichester, England: John Wiley & Sons.

Muradoglu, G. and Harvey, N. (2012). Behavioural finance: the role of psychological factors in financial decisions. Review of Behavioral Finance, 4(2), pp.68-80.

Paramasivan, C. and Subramanian, T. (2009). Financial management. 1st ed. New Delhi: New Age International (P) Ltd., Publishers.

Pompian, M. (2006). Behavioural finance and wealth management. 1st ed. Hoboken, N.J.: Wiley.

Redhead, K. (2008). Personal finance and investments. 1st ed. London [u.a.]: Routledge.

Sewell, M. (2007). Behavioural finance. University of Cambridge. UK

Subrahmanyam, A. (2008). Behavioural finance: A review and synthesis. European Financial Management, 14(1), pp.12–29.

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