‘Needs’ and ‘Wants’ are manifestations of ‘Haves’
A scientific and mathematical study of the financial markets has been a relatively new phenomenon. As the world shrinks with the advent of technology, the interaction between humans has increased manifold especially in terms of commerce. Although several learned men have applied their brilliance towards unraveling the secrets of the financial markets and have collaboratively tried to capture their behavior in a fixed mathematical equation, they have never entirely been able to quantify all the parameters in a stoic equation, the equations have inevitably been inept at predicting behavior by themselves and have always needed to factor in an error term. Behavioral finance is hence another attempt at understanding this error term for unlike other pure sciences, finance is both an art and a science that in addition to being technical, is largely affected by it’s human participants. Theories in behavioral finance are largely in search of an explanation for the behavior of the financial markets in terms of the human element and there have been varied theories that concur on the fact that the financial markets are largely subject to the complexity of human behavior and the human mind. Behavioral finance has hence been the beneficiary of several theories that have successfully incorporated the various facets of human behavior into a framework that explaining a particular phenomenon.
In all the theories, though, there is one common thread running through. All humans will react to every situation differently. As a matter of fact, at different periods in time, even the same individual might make a different choice for the same given situation. What change are the inputs to the way they think because of what they have amassed (or what they have lost) but in either case are subject to the bias that exists because of what they have. Whether achievements or experience (a mere euphemism for failures) our past actions and reactions are responsible for determining our future course of action. All theories, explain a certain facet of human behavior in the light of the existing situation. Most theories are based on empirical evidence and are hence never a definitive explanation to what is going on. Theories in behavioral finance are an attempt at understanding the behavior of the masses and are hence representative theories.
All theories though are subject to exceptions and outliers simply because not all individuals are affected in the same way by the same situation. Whether macro-economic conditions or simply the personal lives of individuals, every component dictates their behavior hence prompting differential behavior even in seemingly similar situations. Behavioral finance is the attempt to factor in all these different ‘biases’ that creep in and to try and subjectively identify the ingredients that go in to the mix. Behavioral finance seeks to put a finger on the seeming irrationality of human behavior which is ascribed to the complexity of human nature. Yet, human behavior isn’t as complex as it is made out to be. Understanding the basic premise that underlines human behavior helps in understanding the apparent complexities. It is a natural tendency for all living beings to strive to be the best and humans are no different. Like everything in nature that builds up on what already exists, humans do the same. Their wants and needs are subject to what they already have. It is the simple fact that underlines human choices and determines their behavior.
For a market scenario, the way humans respond to various stimuli, is determined largely by what they already possess. Behavioral finance is largely concerned with determining the types of choices and the reasons for these choices made by market players, who eventually are humans. No decisions could be irrational for humans process a set of information available to them. Like an equation that incorporates variables into it to arrive at a solution, humans too factor in variables to arrive at decisions. Yet, like mathematical equations that could be wrong if the correct variables aren’t chosen and factored in, humans too go wrong when they do not consider all the factors correctly which makes them irrational (in terms of the simplistic assumptions that well established theories in finance make.) Behavioral finance is hence, the study of the missing variables of human behavior arising out of their ‘needs’ and ‘wants’ which in turn are subject to their ‘haves.’
