Behavioural Finance: How Your Mind Impacts Financial Decisions

Just imagine a circle of friends where all of them are interested in investing. They talk about the latest trends in the stock market, discuss the current hype of a certain stock, and even share tips on where to invest their money. Some of them dive right in and buy the stock on impulse, while others hold on to their losses, hoping that the market will recover. Sound familiar? That's where behavioral finance comes in the study of how our feelings and cognitive biases influence the choices we make with our money. Instead of just looking at the numbers, behavioural finance researches why sometimes we make financial choices that run counter to logic.

So, what is behavioural finance? It's a combination of psychology and economics that helps explain why we make so many irrational choices with money. Things like overinvesting in stock because of a hot news story, holding on to a bad investment longer than we should, or becoming overconfident in our ability to predict the market. By being more conscious of these biases, we can avoid allowing our emotions to get the best of us and make smarter, more considerate decisions about our money.

One of the most common biases all in behavioural finance is overconfidence. Many investors overestimate their knowledge. The overconfidence bias may result in overtrading because we may overestimate our ability to outperform the market. It could be that all those extra trades will just chew up any returns through transaction costs. Suppose that an investor believes he understands how the market works and makes continuous purchases and sales of stocks. In such a situation, he could be losing on every trade.

Another large bias exists around loss aversion: this is the concept that the pain of a loss is much more intense than the pleasure of a gain. Thus, if the value of an investment falls, one may hold on to it hoping for a rebound, long after the prudent action would be to have sold. We simply don't want to realize a loss, even if the alternative to holding on is superior.

There is anchoring, where we allow an initial piece of information to influence our decisions. Suppose you purchased some shares at ₹100 each, and these have come down to ₹50. Instead of booking the losses, you might hold on to those shares, hoping they return to ₹100, even though the market has shifted and that price might never come back. This bias results in our making decisions on data that is either outdated or irrelevant.

A classic example of the herd mentality is perhaps just watching everyone else run with a rush to buy another stock and automatically follow onto the bandwagon before they have any information regarding valuation. The consequence usually takes the form of buying higher through inflated prices, after which that chosen stock subsequently crashes, then crashes. This very principle breeds market bubbles: people eventually invest just because many will do the same thing-.

Another is availability bias: when we make decisions based on information that is readily available to us-for example, recent news reports-rather than doing appropriate research. For instance, if there has been significant media coverage about the success of a company, we may be induced to invest in the company without being fully aware of the risks.

Let's not forget confirmation bias, which is the preference for information that supports our previously held beliefs and the discarding of everything that contradicts them. This is why some investors will not sell a stock in a company that is not performing well. They just focus on the positive reports, which helps them convince themselves the stock will bounce back.

Recency bias leads investors to give far too much importance to recent events. For example, after a market crash, some may believe the downturn will never end, ignoring the long-term patterns that suggest eventual recovery. On the other hand, familiarity bias prompts investors to stick with what they know—like local companies or familiar brands—potentially missing the opportunity to diversify their portfolio and reduce overall risk.

All these biases push us to make the wrong financial decisions, such as over-efforting for short-term results, diversifying too little, and jumping onto trends without thinking them over. It begs the question: how is it possible to overcome the biases?

One very important solution would be setting long-term goals. It helps you avoid emotional decisions based on short-term market swings. Regularly rebalancing and reviewing your portfolio encourages objective evaluation of current values rather than clinging to past expectations. Diversifying across asset classes further reduces the impact of any single biased decision, protecting your overall portfolio.

Last but not least, professional advice will help in keeping your emotions in check. A financial advisor will make you objective, especially in times of market volatility, hence making less impulsive decisions based on either greed or fear.

Conclusion

Understanding behavioural finance and biases like overconfidence and loss aversion—can help you maintain a long-term focus and follow your investment plan, resulting in better decisions.

In the next chapter, we’ll see how adjusting your financial habits can break the paycheck-to-paycheck cycle and guide you toward lasting financial security.