– Prof. Ram B. Ramachandran, Professor of Practice and Vice Dean O.P. Jindal Global University Mysteries of our brain have puzzled human beings for centuries. Neuroscientists and psychologists are still trying to figure out how 86 billion neurons and 100 trillion synapses work in tandem to compute, comprehend and rationalize. Our thoughts, emotions and memories are controlled by the enigmatic 3-pound brain. We make decisions in life sometimes based on empirical evidence and also based on our emotions and biases. We tend to magically create mental short cuts based on conscious and sub-conscious influences. It is specifically pronounced in financial decision making. Financial markets are characterised by volatility, with prices moving in cycles of peaks and troughs. Lately, liquidity fuelled booms and busts have become common occurrences. In light of this, the assumptions of ‘Rationality’ and ‘Efficient Markets’ have been in dispute, but now it is widely acknowledged that much of this market volatility has its source in human behaviour and its quirks rather than fundamentals or quantitative factors. After all, what constitutes ‘markets’ if not their very human participants who make them up, technical trading strategies and algorithmic trading notwithstanding? Analysing Emotions It is becoming increasingly necessary to understand, analyse, and build strategies around human emotions to the extent they move financial decisions and markets. This is where Behavioural Finance comes in. The broader aim of Behavioural Finance is to narrow the gap between the theory of rational investor decisions and their actual behavioural abilities when it comes to making investment decisions. The formal study of Behavioural Finance helps to equip us with knowledge about the principles of psychology of decision-making under conditions of risk and uncertainty. This specialised knowledge can then be deployed to formulate practical applications for managing assets and constructing portfolios. The knowledge is specialised since it combines two domains that are not just technical (psychology/human behaviour and finance) but also as different as chalk and cheese! Thankfully, this niche field has received attention from serious academics from finance, economics and psychology. Individual and Professional Investment As Individual investors ‘suffer’ from behavioural biases, can they turn to professional investors? Well, professionals suffer from similar biases that afflict individuals. In fact, their biases many a time results in overconfidence, familiarity bias and disposition effect. Past performance is no guarantee for future results. Many investors and the markets rely on and follow ‘hot’ fund managers. The ‘hot-hand’ fallacy creates a self-fulfilling prophecy, which can then lead to wild swings when the fund manager goes ‘cold’. The current craze with cryptocurrency and Non-Fungible Assets (NFTs) are partially driven by crowd mentality. Can the wild swings in these new investment vehicles be better predicted and managed? The need for Behavioural Finance The need for such specialised knowledge is becoming obvious given how much finance and economics have gained from insights about psychological processes. Five Nobel Prizes in Economics have been awarded for path-breaking work on cognition, nudge theory, market behaviour and decision making, which now offers a deeper understanding of…
