Behavioural finance and common mistakes

Herbert Simon won a Nobel Prize in economics in 1978 for his research where he proved that financial decisions of humans are not only based on one’s ability of mathematical calculations, it is equally connected to how that individual is behaviorally wired up. So the research said that people do not think through all decisions. It’s not possible for them to spread thin as far as brain’s functionality is concerned. People make ‘good enough’ decisions and that’s the precise reason we hear most of the times, “I had decided what looked best at that point of time.”

How our decision-making process works is interesting. The human mind is conditioned to make patterns of everything. The way you drink your daily cuppa or the train you catch for work, it’s all patterned. ‘Heuristic’--enabling a person to discover or learn something for themselves--is the rule of thumb. The way we decide and judge everything is called ‘representative heuristic.’ It is a pattern of thoughts. A simple analogy here: During heavy rains, your better half is delayed by three hours. The mobile is switched off and now you are on tenterhooks. The most dreaded thoughts are on your mind and that is scary. The instant pattern is worry and fear. That’s exactly what happens in finance-based decisions. Age old and reactive patterns kick in. No reasoning needed.

But Peter A Ubel, author of ‘Free Market Madness: Why Human Nature is at Odds with Economics--and Why it Matters’, highlights the role of probabilities in financial decisions. Let’s understand it in an easy way.

You participate in a game show. Choices are

1. Win Rs 10,000 and leave the show.
    
2. Probably win Rs 20,000 and leave the show with it or without anything. 

The second one is a loss-making proposition. You might lose totally. The instant choice would be taking a sure shot money and move out. People view situations very differently when the situations are described, and instead focused on losses. If an expensive cancer treatment says that it has 90% of survival rate, it will sell far easily than an advertisement that says it has 10% mortality rate.

Now a roadmap to save yourself from falling prey to patterns and probability.

1. Are you motivated: Check your self-motivation to spend. Are you looking forward to the new buying or is it just out of peer or family pressure? Are you looking at probable decision-making? For example, the compulsion of sales because there will be a price increase next week. Auto majors apply this trick to customers in the month of December.
    
2. Review past financial decisions: We all have stood at a rubble of wrong purchases, financial decisions and looked at it in complete dismay. Rethink that past incident. And check ‘why you took that decision in the first place.’ Give yourself some time. Remember: haste leads to waste.
    
3. Future can’t be predicted: A friend of mine had kept floating rate of interest on his home loan rates where the fixed rate was available though a tad expensive. Later he regretted the decision as floating rates went much higher. There is no way to look into a crystal ball, unless you inherited Nostradamus’s DNA, no way one could do prophecies.
    
4. Regret aversion: James Remiraz, CTO of Essentia Analytics, helps people to rethink before making a bad financial decision as he shares an interesting insight. ‘Most people repeat similar mistakes. They think, that last time they could not board the bus, so this time they sure will.’ One more failure leads to heartbreak now.

Human beings are not rational by behaviour. Uncertainty kicks in fear and fear leads to a wrong judgement. We don’t always choose what’s best for us. With information on our fingertips, we can try making sound financial decisions and not let patterns mislead us.

The writer is a strategic advisor and premium educator with Harvard Business Publishing