Achieving long-term financial goals requires investing, and the choices investors make have a big impact on their results. But studies have shown that people are not always logical in their investment choices. The study of how psychological and emotional elements influence financial decision-making is known as behavioral finance, and it has grown in importance over the past several years.
Emotional Influence on Investment Decision Making
Financial decisions are frequently motivated by emotions like fear and greed. For instance, during a market fall and panic, investors may experience dread and anxiety and sell their investments at a loss. On the other side, during a market boom, investors may grow greedy and invest excessively as a result of their overconfidence.
Financial research firm DALBAR's studies have repeatedly demonstrated that the ordinary investor considerably underperforms the market as a result of making emotional decisions. According to their 2019 analysis, the average mutual fund investor only earned a return of 9.87% over the past 20 years, vs a return of 6.06% for the S&P 500. This can be attributed to the fact that many investors make irrational decisions based on emotions rather than sound investing principles.
Cognitive Biases' Effect on Investment Decisions
Our brains use cognitive biases as mental shortcuts to streamline difficult decision-making processes. These short cuts, nevertheless, frequently result in unreasonable and flawed judgment. There are a number of cognitive biases that may affect investment choices, including:
The propensity to seek out information that supports our preexisting opinions and overlook information that challenges them is known as confirmation bias.
Anchoring bias is the propensity to base decisions solely on the first piece of information we are presented with.
Overconfidence bias: The tendency to overestimate one's own knowledge and skills.
Investors may make illogical investment choices as a result of these cognitive biases, which may have a detrimental impact on their investment returns.
Behavioural Finance's Importance in Investment Planning
Investors might choose more wisely by becoming aware of how emotions and cognitive biases affect their judgments. Financial consultants that are familiar with behavioral finance can provide their clients with tips on how to get over these biases and make wiser investing choices.
Focusing on long-term objectives and creating an investment plan around them is one such tactic. By using this strategy, investors can steer clear of snap judgments driven by their feelings and concentrate on attaining their long-term goals.
Another tactic is to diversify assets across several asset classes and industries in order to lower risk and boost the possibility of longer-term, better returns.
Conclusion
It has been investigated how behavioral finance affects investment decision-making, notably in the setting of a few Nigerian investment banks. The empirical findings confirm prior studies and aid in generalization by showing a beneficial relationship between behavioural finance and investment decision-making. The study also reveals important connections between prospect theory and individual investment decisions as well as between heuristics and heuristics and individual investment decisions. Furthermore, both heuristics and prospect theory have strong and unfavorable correlations with investment choices, as do other research findings. Therefore, it is advised that both institutional and individual investors become knowledgeable about the many behavioural elements, such as heuristics and prospect theory, that can influence their decision-making process while making investments.
