Decision-making process entails handling complex situations. Kahneman (1982) describes it as a cognitive practice to prefer an alternate among numerous potential substitute scenarios. Decisions cannot be made by entirely depending on one’s resources. According to Kahneman (1982), failure to plan before making decisions may be very devastating to a person. The author posits, “A manager’s mental approach mediates the different problems occurring in different steps by analyzing them” (Kahneman, 1982, p. 50). Investors who want to succeed in today’s business environment need to make informed investment decisions. They can achieve this by embracing behavioral finance. Behavioral finance refers to how people analyze and work with information to make well-versed investment resolutions. It helps investors make better investment decisions when faced with a number of alternatives.
Not all the investors behave realistically when making investment decisions. Kahneman (2003) claims that the behavioral finance turned out to be an integral component of the procedures of decision-making since its impacts affect the performance of the financier. Behavioral finance assists investors to make better financial decisions and avoid errors in the future. This paper will discuss how behavioral finance help investors make better investment decisions.
Scholars spend most of their time analyzing investment behaviors. They take the time neither to study investors’ behavior nor to understand that investors’ behavior dictates investment habits. No matter what an investment does, “it is the decision of the investor to buy or sell that ultimately determines success or failure” (Kahneman, 1982, p. 54). Behavioral finance is all about the unusual behaviors that individuals portray when spending their financial resources. The main question is if psychology is crucial to investing. The question can be answered by analyzing what one feels about the market. A person may be considered a reasonable investor if he or she experiences fears, depression, concern and panic about the market. One wonders why investors haste to purchase shares when they are selling highly only to sell them later when their value is low. Understanding behavioral finance can help one to avoid making mistakes when coming up with investment decisions.
According to Kahneman (1982), regret theory imposes that many investors regret after learning that they have made a mistake in their investment decisions. For instance, investors feel sorry when they realize that they have purchased premium bonds or shares which value do not increase with time. They get psychologically affected by the cost they incurred to buy the shares. Therefore, the investors refrain from selling the shares as a way to avert the lament of having made the wrong investment decision. In such a case, behavioral finance helps investors make informed investment decisions by evaluating the chances of one repeating a past investment mistake (Kahneman, 2003). Kahneman (2003) alleges that people’s mind automatically build up psychological shortcuts alternatively referred to as rules of thumb. The alternatives help investors make a quick analysis of potential investment options. However, the major error that investors make is generalization of things. For instance, an investor might decide not ever to buy shares again because he or she made a loss in the past. Making loss once does not mean that all stocks are risky. Understanding such underlying mental shortcuts can help an investor to make better investment decision. Behavioral finance makes investors understand that their instincts are not always right. Hence, investors take risk to channel their funding to investments that seem to be risky.
Some investors suffer from innumeracy. This is the failure of the investors’ because of failure to analyze problems in time manner (Kahneman, 2003). Consequently, many investors have a tendency to underrate the rate of recurrence of randomness. Instead, they consider randomness as fluke. According to Kahneman, “most people think the odds are pretty small because they do not have a good sense of how easy it is for coincidences to occur” (2003, p. 97). The major setback of innumeracy is that investors make investment decisions through guess work. They only decide to invest when they are assured of returns. Behavioral finance encourages investors to be obstinate when making investment plans. Thus, investors stick to their investment plans no matter how high the costs are and not to regret about their decision. One of the characteristics of an entrepreneur is risk taking (Thaler, 1980). Consequently, behavioral finance makes investors take risk even if it might look big. They cease to make decisions based on their emotions and start to evaluate the cost of not investing rather than the cost of investing.
Proper research and accurate information are critical for decision-making. For one to decide on an investment, it is imperative to gather information about it and evaluate all the risks and benefits associated with the investment (Thaler, 1980). Sorry to say, many of the investors who make uninformed decisions are more susceptible to making pitiable judgment stimulated by emotions. The available information tends to influence investor’s behavior (Thaler, 1980). For instance, investors make decisions based on the information they get concerning the market. That is why people invest heavily in companies that appear to be doing well without thinking about the future of the respective companies. Behavioral finance understands that some of the financial reports are published by institutions that are out to make money (Thaler, 1980). Therefore, investors who use behavioral finance do not make their judgment based on what is in the media. Instead, they scrutinize the investment and overcome their feelings. Investors no longer affix their decision to a fixed point. Such a position makes it hard for investors to conduct market analysis prior to making investment decisions.
For behavioral finance, pain is critical to sound investing (Thaler, 1999). It is hard to predict the future of any investment. However, what investors need to know is that no right or wrong situation is eternal. Behavioral finance believes in this hypothesis. It sees the investment world as a sea, which at times is calm and full of tides at the same time. Therefore, it encourages investors to focus on the benefits that they can accrue when investment environment is promising. Investors are discouraged from paying attention to emotions, which in many cases make them believe that they might lose their money by investing in a certain area. Behavioral finance helps investors see all the aspects of decision making (Thaler, 1999). As a result, it assists investors to assume a more cogent position and stay dedicated to lasting objectives and plans during market turmoil. Besides, it contributes to the success of investors because it familiarizes them with right reference points, which are forging ahead and looking for new opportunities.
Kahneman, D. (1982). Judgment under uncertainty: heuristics and biases. Cambridge: Cambridge University Press.
Kahneman, D. (2003). Maps of bounded rationality: psychology for behavioral economics. The American Economic Review, 93(5), 95-134.
Thaler, R. (1980). Toward a Positive Theory of Consumer Choice. Journal of Economic Behaviour and Organization, 1(1), 39-60.
Thaler, R. (1999). Mental Accounting Matters. Journal of Behavioural Decision making, 12(1), 183-206.