Behavioural finance is a field of study that combines principles from psychology and economics to understand how people make financial decisions, including their attitudes towards risk. It suggests that individuals often deviate from the rational decision-making assumptions of traditional finance, such as the efficient market hypothesis. Instead, behavioural finance recognizes that people’s emotions, biases, and cognitive limitations can influence their risk attitudes and investment choices.
Here are some key insights from behavioural finance regarding people’s attitudes toward risk:
1. Loss Aversion:
Behavioural finance posits that people are generally more averse to losses than they are motivated by equivalent gains. This means that individuals often prefer to avoid taking risks that might lead to losses, even if the potential rewards are significant. Loss aversion can make people more conservative in their investment choices.
2. Prospect Theory:
Developed by Daniel Kahneman and Amos Tversky, prospect theory is a cornerstone of behavioural finance. It suggests that people evaluate potential outcomes in relative terms, rather than absolute values. This leads to nonlinear risk attitudes where individuals are more risk-seeking when faced with potential losses and more risk-averse when faced with potential gains.
Behavioural finance identifies overconfidence as a common bias, where individuals tend to overestimate their own abilities and underestimate risks. This overconfidence can lead people to take on more risk than they should, believing that they are better equipped to handle it than they actually are.
4. Availability Heuristic:
People often rely on readily available information and recent experiences when making financial decisions. This can lead to biased perceptions of risk and reward, as well as herd behaviour, where individuals follow the crowd without fully assessing the situation.
Behavioural finance suggests that individuals may anchor their financial decisions to certain reference points or benchmarks. For example, if someone bought a stock at a high price, they may hold onto it, hoping for it to return to that price, even if it’s not a rational decision based on current market conditions.
6. Mental Accounting:
Behavioural finance acknowledges that people compartmentalize their money into different mental accounts, such as emergency funds, retirement savings, and discretionary spending. These mental accounts can affect risk attitudes and decision-making within each account.
7. Regret Aversion:
People often make decisions based on their fear of regret. They may avoid risky investments to prevent the possibility of regretting their choices, even if those investments have the potential for high returns.
8. Herd Behaviour:
Individuals sometimes follow the actions of others, assuming that the collective wisdom of the crowd is a safe approach. This can lead to bubbles and crashes in financial markets, as well as suboptimal risk management.
In summary, behavioural finance suggests that people’s attitudes towards risk are influenced by a wide range of cognitive biases, emotions, and heuristics. These deviations from traditional economic models can lead to suboptimal financial decisions and risk management strategies. Understanding these behavioural factors is essential for investors, financial advisors, and policymakers to better address and account for the complexities of human decision-making in the world of finance.