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The Role of Behavioral Finance in Shaping Retail Investment Decisions

IFSA LSR
Authors: Vanshika Jain, Ananya Jha, Ritika Singh
Published on: March 7, 2025

Introduction

In the world of finance and investment, it does not matter at all how strongly one can crunch numbers or monitor the market fluctuations. The investments are made keeping in mind the human instinct towards the field with their experience going beyond the analysis of the company’s stock and market. Behavioral finance is considered to be a study that understands the influence psychology has on investors or financial analysts’ behavior. It also encompasses the subsequent effects on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.

Economics assumes rational decision-making and efficient markets, relying on mathematical models, while behavioral finance explores how emotions and biases influence investor behavior, leading to market anomalies like bubbles and crashes.

There are certain factors that drive irrational decision making- Emotions. Overconfidence, Loss Aversion, Herd Mentality.

Reflective insights on a decade of behavioral finance journeys by Richard Thaler, Daniel Kahneman, and Meir Statman. The key contributions to behavioral finance. Kahneman looked into bias, optimism, and overconfidence in making decisions. Thaler spoke of understanding market psychology for better returns. Shiller addressed the changing nature of economic thought. Statman introduced second-generation behavioral finance as associated with AI, ESG investing, and global events. Theirs are reflective insights on the role of psychology in finance.

Relevance of Behavioral Finance to Retail Investment Decisions

Behavioral finance is very helpful to the retail investors, as it allows them to understand how emotions and cognitive biases drive their decision making process, leading to irrational decisions such as panic selling or overconfidence in picking stocks. These biased decision making processes lead to a fall in the investment returns. The key investment in such biases is more rational data-backed decisions that improve long-term financial outcomes, which investors can attain if they can identify and avoid such biases. It also indicates the need for diversification, patience, and refraining from acting impulsively to market fluctuations. Behavioral finance provides retail investors with strategies and measures that can help manage risk, remain rational, and thus achieve better financial stability.

Case Study (Game Stop Saga)

This retail company specializes in video games but, like almost every other kind of business, was severely shaken by the impact of the pandemic. The total number of shut-down stores under this company amounts to 462 in 2020. There was an unintended starnge factors that helped the company stock go up drastically by more than 1600% in the month of January. GameStop, whose trading price had slipped to as low as $2.57 in April 2020, gained a peak to $483 by January 2021.

The retailer is caught between institutional investors fighting against retail investors, and when the company performs poorly, hedge funds are looking out for an opportunity to short the stock hoping they will gain on the price falls as expected. On the retail side, on the other hand, there exists a retail opinion (biased) that appears to be fuelled by Reddit’s WallstreetBets community. They then began buying the stock in large quantities. The latter enthusiasm proved so excessive that it caused the price of GME to pump enough for a short squeeze to be unleashed. GameStop became a “meme stock,” all thanks to the Reddit community, and has lost hedge funds billions of dollars.

This deviation from rationality is reflected by a price surge that cannot be justified by fundamentals, but instead by investor’s excessive enthusiasm driving asset prices higher than their intrinsic value. Ultimately, the bubble bursts and asset prices declined drastically because of market wide panic. Since revenues continue to decline, the company was not able to adapt with the changes in the video game market. While most modern consumers download games online, the company still holds on to their physical stores. Now with restrictions and limitations during the pandemic preventing people from shopping in malls, it is rather difficult to fathom any sort of prospects for the company.

GME chart via Yahoo Finance

Themes of Investor Behaviour

Rightfully named, behavioral finance is nothing if not prevalent in aggregate in ordinary life. It is the concept that analyses the financial decisions made by people, who are presumed to be “normal” instead of “rational” via a series of psychological notions. Unlike traditional finance, it does not assume any predefined traits of the population while studying their decisions and their outcomes, i.e., individuals may exhibit entirely random characteristics and patterns. According to behavioral finance theory, several types of cognitive biases can affect an investor’s judgment — overconfidence, loss aversion, herd mentality, and more. This section will present discourse on various behavioral theories relevant to economics and finance and their bearing on the day-to-day events of an individual’s life. 

Behavioral investing encompasses all those psychological and personal factors that influence the investors’ decision making. Studies have shown that more than 65% of retail investors make their investment decisions based on emotions and cognitive biases instead of the actual data. The factors affecting the decisions are characterised so distinctly that it would be convenient to say that the behavioural factors are classified into the following categories:

 

Themes Behavioral Factors
Heuristics Illusion of Control, Representativeness, Anchoring, Mental Accounting
Prospect Theory Loss Aversion, Reference point, Probability Weighting
Emotions Regret Aversion, Fear and Greed Index, Overconfidence Bias
Market Impact Overreaction to Price Changes, Past Trends of Stocks
Herding Herding

 

Heuristics are efficient rules of thumb which are used as a shortcut during complex decision making processes. Tversky, the father of behavioural finance, defined it as a strategy which can be applied to a variety of problems that usually–but not always–yields a correct solution. Few key heuristics are:

Representativeness occurs when the investment decision is based on superficial similarities of a stock whose past performance resembles closely to the current stock under consideration. This often involves neglecting statistical data and thorough analysis which leads to irrational financial decisions.

Illusion of control refers to an inflated sense of control which makes the investor overestimate their ability to infer uncertain situations , for example: wrongly predicting the market movements and ignoring potential risks which ultimately leads to investors failing to diversify their portfolio and over-trading.

Anchoring is a heuristic that involves placing importance over unnecessary information and using it as a reference point to make subsequent assumptions about the element in consideration. Marketers often use the original, higher price as an anchor to make a sale price seem more attractive. By showing a higher initial price next to the discounted price, the consumer’s judgment is anchored to the original and higher price. During end-of-season sales in fashion retail, items might be marked down with a “50% off” label, but the original price could have been inflated. Consumers, however, feel like they’ve got a great deal and saved a lot of money, even if the actual discount isn’t substantial.

Mental Accounting is the subjectivity in deciding the value of money depending on its source. It is easier to justify spending a gift card on a Starbucks coffee than using our hard-earned Rs 250. It’s the tendency to assign different levels of importance to money based on how it was obtained. In layman’s terms, one is likely to spend lavishly if they’ve won that money in a lottery while carefully budgeting their paycheck from work.

Example in Retail: Fast food chains like McDonald’s offer meal combos like “Happy Meals” where you get a burger, fries, and cola at a lower price than if you would have purchased the items separately. Customers delude themselves into believing that they are ‘saving’ their money, even though the total cost of the meal is higher than the individual prices. The “anchor” here is the perceived savings from buying the bundle versus individual items. However, they end up paying more for the combo than if they’d just purchased one or two items from the menu instead of more.

Example in Financial Market: Say, the S&P 500 is in a bull market and its current value is 2000, analysts are likely to make predictions closer to this value. However, presenting forecasts solely keeping historical values as a base can be misleading, as the volatility of the index is represented by its standard deviation (the higher the deviation, the greater the volatility, the more inaccurate the predictions). In fact, during the 2008 financial crisis, something similar happened. Many analysts and investors were ‘anchored’ to values pre-crisis and were expecting housing prices and stock market values to return to normal levels. They did not make preparations for the opposite to happen and this cost about $17 trillion in inflation-adjusted terms.

Prospect Theory explains how investors make decisions when presented with risk, uncertainty and probabilities. Proposed by Amos Tversky and Daniel Kahneman, this theory suggests that the pain of a loss is more impactful than the euphoria of a gain, even if the gain is exponentially higher than the loss. It usually entails the following features:

Loss Aversion distorts the investment decisions, as investors fear losing a certain amount more than gaining an equivalent or even larger amount.

Reference point: Investors evaluate each outcome’s potential gain in relation to a reference point, focusing more on relative utility than its absolute worth. For eg 

Suppose two investors A and B, bought infosys stock

Investor A, bought at Rs.1200/-share

Investor B, bought at Rs.1800/-share

Today, the stock is trading at Rs.1500/-share. For Investor A, this is Rs.300 gain, whereas for Investor B, this is a Rs.300 loss, even though both investors now hold Infosys stock at Rs.1500, their perceived value is different because of their relative reference points.

Probability weighting refers to the tendency of investors to overestimate low-probability events and underestimate  high-probability events. For instance, an individual is given a choice. Rs 50 is handed outright in the first option. For the second, a Rs 100 note is given but Rs 50 must be returned. While the end result is the same – Rs 50 – a person is likely to choose the former option since it’s a single and an immediate gain instead of a gain followed by a loss, as depicted by the second option. This is because individuals automatically assume the probability to be 50/50 instead of seeing it for what it is.

source: www.corporatefinanceinstitute.com

Example in Retail: Another element of prospect theory is hyperbolic discounting. Consumers tend to prefer immediate rewards over future benefits. When payments are to be made in installments, it makes the product feel less costly. Big retail businesses like Amazon or high-end brands like Apple appeal to such techniques. When promoting tech appliances and gadgets like smartphones or laptops, companies often offer EMI options with low or even 0% interest for a limited time. For example, an iPhone priced at Rs 60,000 might be framed as “Rs 2,500 per month for 24 months” instead of Rs 60,000 upfront.

Example in Financial Markets: Investors hold on to losing stocks in the hopes that the market will rebound. Conversely, they might even sell stocks earlier to avoid a loss. Market players with a strong loss aversion usually have conservative portfolios with little to no diversification, leading to underperformance. 

Emotions play a major role, while making financial choices since they form the basis of behavioral finance, some major emotions observed in the stock market are

Fear and Greed Index assesses majorly two emotions that drive the market behavior: fear and greed, the two opposing emotions that cause unpredictability and volatility in the stock market. When investors are excessively apprehensive, stocks may decline below their intrinsic value, whereas when investors become profit-driven, the stock prices get inflated.

Regret aversion is a psychological phenomenon in which investors try to minimize or avoid an anticipated regret, by making the wrong decision. For instance, an investor might hesitate to sell a stock that has recently gained value in the apprehension of losing an expected gain. In the case study introduced at the beginning of this paper, investors, while reluctant at first, joined in on the movement due to the fear of missing out.

Overconfidence Bias is ego-driven cognitive bias that occurs when individuals overestimate their knowledge and skills of investments and financial markets, disregarding facts supported by research and other data.

Example in Retail: A wine-loving customer bought nice wines from Tuscany at low prices. The wines have greatly appreciated in value, so that a bottle that cost only $70 when purchased would now fetch $250 at auction. This customer now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price. This is also called the endowment effect, and is a byproduct of the regret or loss aversion bias. People often demand much more to give up an object than they would be willing to pay to acquire it. In this example, the customer holds on the wine in the hopes of the value increasing even further.

Example in Financial Market: Overestimating your knowledge of the market or a particular stock can lead to risky decisions, such as overinvesting in high-risk equities that are more likely to lose money or trying to time the market. Markets, oftentimes, take longer than expected to recover, and if one irrationally invests in highly volatile stocks without considering other economic factors, they can face severe losses.

Market Impact

Overreaction to price changes occurs when investors react unreasonably to a piece of information, without doing the fundamental analysis which eventually leads to an excessive buying or selling of securities.

Past trends of stocks drive investment decisions as retail investors are significantly influenced by them due to psychological reasons, they overemphasize recent performance of the stock as an indicator of future returns causing poor investment decisions.

Herding

Humans are social beings, so conforming to societal norms comes naturally, be it a ‘keto diet’ or the viral ‘glass-like skin texture’ of 2024. Herding occurs when investors heavily rely on the opinion of the masses while making their investment decisions, rather than conducting their own fundamental analysis. This is usually because people are hard-wired to follow the herd, and find it psychologically painful to go against the crowd. Investors are motivated by feelings of uncertainty, dread, and greed, which ultimately leads to significant inefficiencies in the market like asset bubbles, rapid price fluctuations, etc. When Redditors started posting about Gamestop’s success, other investors were triggered to follow the crowd, eventually costing hedge funds billions of dollars in losses.

Example in Retail: Herd mentality is most evident during the launch of a new model of the iPhone. A large number of consumers camp out in front of Apple stores, sometimes for days, to be the first to purchase this status symbol.

Example in Financial Markets: A prime example of this cognitive bias is evident in financial markets. Bitcoin and the cryptocurrency market experienced an explosive hike in price in 2017. By December of that year, Bitcoin skyrocketed from $1,000 to close to $20,000. In financial markets, this herd mentality may lead to the creation of an ‘asset bubble’ – inflated asset prices due to people mindlessly copying the actions of other people – only to drop when the trend reverses. In early 2017, bitcoin was trending, and more retail investors joined in, driven by the fear of missing out. They believed they could get rich by owning Bitcoin from the early on; hence people started buying the hype, leading to the ultimate downfall of Bitcoin price. The sky-high price of Bitcoin ended up crashing down and after the halcyon days of the speculative frenzies, investors lost massive amounts of money when the bubble burst.

Conclusion

Behavioral economics research will be advanced with new theories and biases that would allow for a better understanding of the psychological factors driving financial decisions. These findings would be translated into policy and regulation, as governments and regulators employed interventions to guide people toward good financial behaviors such as saving and investing wisely. This will integrate behavioral finance with FinTech to develop innovative investment platforms that provide personalized advice and automated tools for making smarter decisions, reducing biases like emotional investing, and improving financial outcomes through technology.

 In conclusion, behavioral finance is the basis through which retail investors make their decisions focusing on the psychological factors that rule their choices. Biases such as overconfidence, fear of losses, and following the crowd lead to irrational investment decisions. Understanding such behaviors helps investors make smarter decisions, and financial advisors can devise strategies that address these behaviors. The ultimate outcome is the betterment of investment results using insights from behavioral finance for retail investors.

 

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