The applications of behavioural finance are probably most appreciated in the field of investment management with ‘behavioural engineering’ having become an important part of the strategy of major financial institutions and their drive to improving returns.
What is behavioral finance?
Behavioral finance is the study of finance from a psychological perspective. It is randomly applied by academic researchers and Fintalent’s behavioral finance consultants in domains such as investment, trading, entrepreneurship, and accounting.
The origins of behavioral finance are generally credited to psychologist Daniel Kahneman who published his book “Thinking Fast and Slow” in 2011. The following year in 2012 he won the Nobel Prize in Economics for this work.
One factor that differentiates behavioral finance from traditional microeconomics is that it focuses on irrational but common human behavior, as opposed to rational economic theories which focus on maximizing one’s utility (profit). In other words, behavioral economics acknowledges that humans may not act rationally when making decisions about their finances.
Behavioral finance is also distinguished from behavioral economics in that behavioral finance provides a quantifiable and testable hypothesis about the amount of irrationality or non-rational behavior in humans. Without knowing this, it is impossible to quantify human behavior when making financial decisions and devise a method for measuring success.
The first core belief of behavioral finance is that people act irrationally with respect to their financial decisions, as this irrational behavior can lead to undesirable outcomes. To study the idea and its behavior, academics have developed models of decision-making. Some of these models are based on traditional economic theories, while others employ more subjective elements such as psychology. The latter type of models have become increasingly popular in recent years.
Understanding how human psychology influences economic decisions is crucial to studying economic behaviour. Understanding the application of such knowledge in organizations is an important development for the future of financial knowledge, since it can be applied to many different fields. The value of combining such knowledge will not only be in providing a greater understanding of how to make better decisions, but also in encouraging constructive behaviour within organizations by helping managers to understand their employees’ motives.
A principal feature of behavioural finance is its focus on the cognitive processes that people use when making decisions. It draws on a variety of theories and concepts from psychology and sociology in order to understand how people make investment or consumer choices, or work in organizational settings.
Behavioural Finance: The Business Organisation’s Perspective on Behaviour:
The business organisation’s perspective is one that looks at behavioural finance through its employees’ eyes, which is a very valuable perspective because it allows businesses to view their business in a new way. Businesses’ employees can gain the skills required to solve problems by taking an active role in identifying possible solutions and approaches to problems. This is a very important way for businesses to make their organisations more productive in the long term, because it is only through having a better understanding of their own company that they will be able to build strategies that promote greater efficiency.
Behavioural Finance Incentives and Rewards:
This topic discusses how rewards drive employees and how behaviour based systems work in business. The perspective here is that rewards are designed so they will motivate people towards certain behaviours without the need for coercion or threats of punishment. Of course this is easier said than done, but there are certain key factors that should be considered when introducing a reward system and they are as follows: what do you want people to do? why do you want them to do it? how are the rewards going to motivate that behaviour? how long will the rewards last? what will you reward? and is there enough money available to fund the rewards in a timely manner? There are two types of reward systems, person based or team based. The use of both these systems depends on the specific business requirements.
Businesses also need to understand that not everyone will respond in the same way to incentives. In some cases, employees will simply lack an incentive to perform the desired behaviour because they feel it is not in their own self-interest. It is important then that companies consider this when designing a reward system in order to maximise the number of employees who will be motivated by its rewards.
Behavioural Finance and Organisational Change:
Understanding the principles involved in behavioural finance can help organisational change be achieved more effectively than if it were driven purely through incentives or coercion. In other words, understanding why people behave in certain ways and how they are affected by incentives can give organisations the necessary understanding to effect organisational change. Organisations that have a better understanding of how people act will be able to tailor their policies and procedures so that these behaviours are more effective. For example, it is important for an organisation to understand the concept of loss aversion. According to behavioral finance theory, loss aversion means that individuals and businesses are inclined to avoid losses more than they prefer gains. This creates a situation where any decision made means there is a risk in performing the action.
Behavioural Finance Incentives: A Framework For Understanding Motivation: Once an organisation’s objectives have been defined, behavioural finance theory can help them design effective rewards systems to ensure that people do what they need to do and achieve their goals. An effective reward system will encourage people to work together, achieve common goals and improve overall performance. There are three basic areas that organisations need to understand in order to build this framework: self-interest, loss aversion and fairness and equity. First of all, understanding the concept of self interest will enable organisations to understand why people act the way they do. This is very important as it gives businesses a better understanding of their employees’ motivation levels and what motivates them. Secondly, it is important for an organisation to consider the concept of loss aversion. Organisations should also have a sound knowledge of their employees’ perception regarding fairness and equity in order to truly understand how they think and make decisions. Finally, an understanding of what is fair and equitable will enable organisations to design effective rewards systems that do not encourage loss aversion behaviours or cause inequalities in a workplace.
Behavioural finance is an important concept in the context of organisational culture and behaviour. Therefore, businesses need to understand that behavioural finance is based on the theories of psychology and how people respond to incentives. In addition, businesses should also take into account the demographics that they employ their employees from. Therefore, it is important for organisations to understand what their main demographics are; age, gender and race/ethnicity. It is also important for businesses to understand the different levels of their employees’ education, experience and skill sets. This will allow them to better plan and design their motivational strategies to meet the needs of each type of employee.
Behavioural Finance and Ethical Dilemmas:
One of the most important things that companies can do in order to combat unethical behaviour is to make sure that they have an ethical strategy in place before they engage in behaviours that are not ethically sound. The behavioural finance theory discussed earlier goes into how people respond differently when faced with ethical dilemmas. Therefore, businesses should have a clear ethical strategy that they want to follow and the behavioural finance theory will help them formulate this. In order for this strategy to be effective, it is important for companies to understand the ethical dilemmas that are faced and how people respond. The following areas will help organisations develop this understanding: fairness, equity and morality.
Businesses need to also take into consideration what their employees believe is fair and equitable, as well as their perception of how other people are behaving. An effective ethical strategy would include how businesses plan on grouping their employees in the workplace. Like it was stated before, everyone will respond differently to incentives, therefore, it is important for organisations to understand their demographics and how they will affect their ethical strategy. It is also important for businesses to take into consideration the ethical dilemmas that are specific to that industry. For example, financial services businesses have a difficult time integrating a code of ethics while they are simultaneously being pressured by their superiors and shareholders to meet firm level financial goals.
Behavioural Finance and Business Risk: Behavioral finance theory can help organisations understand why risk aversion exists and why people do what they do when faced with uncertainty.
In sum, behavioural finance is a very important concept for organisations to understand in order to engage in effective behaviour change. It is imperative that organisations have a good understanding of how people respond to incentives, how they make decisions and what motivates them. This knowledge can be utilised in order to create a positive corporate culture and increase overall productivity within their businesses. Furthermore, behavioural finance can help an organisation plan and design the best rewards system possible so that employees are motivated by their incentives.
