How individual and group behavior influences you financial planning – Every MBA aspirant must understand

qSo, you want to do MBA after your graduation in another stream. Your decision to go for MBA is hopefully based on your cost-benefit analysis of investing the time and money in the near future versus gaining substantially more benefit in the long term of your life time. The benefits can be in the form of a higher level starting placement involving good company, greater responsibility and bigger package. Ultimately it may lead to faster growth trajectory for career, status, recognition and on the whole superior quality of life, greater job satisfaction and enhanced happiness.

Most students go for MBA based on herd-mentality thinking that when everyone is going towards MBA, I shall also do the same. They don’t do any financial planning or rather they don’t do any planning at all. The talents and aptitude differ from person to person; family circumstances and requirements vary greatly. What is good and appropriate for one may not be the same for another. Thus, one can see that decision making is based more on emotional and social factors than any logical and rational thinking and planning.

The MBA aspirant wants to get qualified and trained to enter the business world. He or she wants to succeed in business career which may be employment or self-business. Let’s consider what is most important in business, and fortunately it is common factor in every business is the way money is handled. All businesses are operated with money as the central nerve system for the purpose of generating more money. Every step in business involves money to be invested. Investment decisions are every day or rather every minute decision. The question is whether money is being invested in business as per well thought out rational plan or based on impulses, emotions and following others’ actions? To take an example, a large company may go for massive television publicity campaign for its products; if a smaller competing company also does the same, it will be doomed. Therefore, it is essential that during the MBA program, besides learning subjects like marketing, human resources, finance etc. the student must at all times keep his focus on learning how to deploy company funds and resources effectively and efficiently towards achieving the overall superior performance of the firm.

Now come to the stage when the individual has successfully completed MBA course and entered professional life. At this stage the person would be required to invest the company funds and also his own personal funds to meeting their respective long term and short term goals. This is the time when the knowledge and grasp in the field of behavioral finance would be put to acid test.

The emerging field of behavioral finance examines psychological and sociological factors which impact the decision making process of individual investors and firms. Thus behavioral finance encompasses the concepts of psychology, sociology and traditional finance.

Psychology involves study of behavior and mental processes together with the effect of a person’s physical/mental state and external environment on these processes. Sociology involves study of human social behavior. It includes influence of group behavior on attitude and behavior of persons.

Traditional finance is concerned with assessing value and making business decisions. It includes functions of acquiring, investing and managing financial resources. Theories in academic finance are called standard finance.

It is observed that investors tend to make some very strange choices. Their behavior deviates from logic and reason. They think as a group and make irrational decisions. They exhibit many behavioral biases which influence their decision making. Some commonly observed biases are explained below;

  1. Herd behavior: Investors generally follow what most other investors are doing. If the price of a share is consistently moving up, implying many people buying it, other investors also want to invest in the same share. The belief is that what everyone else is doing must be good and therefore I can indulge in it without applying any financial analysis. Thus investors often buy shares which already had a good run up and are at the peak. When the share price goes down they are left holding it and they want to retain it in the hope of its recovery. Much later they realize their folly when lot of damage has already been done.
  2. Overvalue losses and undervalue gains: Investors are more affected by loss in value compared to similar gain in value. For example, if an investor has made two investments of identical value, when one advances in value by ten per cent and other goes down in value by ten per cent, the investor is more concerned with the loss than satisfaction over similar gain elsewhere.
  3. Regret bias: Investors do not sell investments that turned out to be declining in value. They hold on to these investments hoping future price increase and break-even. In the process they incur much bigger losses. On the other hand investors are too eager to realize gains. Generally gains signal good investments and losses signal poor investments. The tendency to hold on to ‘losses’ and selling ‘winners’ violates basic of rational investing. The psychology behind such phenomenon is that people are averse to booking losses and thus internally admitting to themselves a bad choice or decision made earlier.
  4. The present bias: It implies that investors want to shift good experience i.e., consumption to the present and bad experience i.e., making difficult decision regarding savings and investment to the future. This often leads to over-consumption and procrastination. Investors may be patient while examining two or more future return from investments, but become impatient while examining choices and decisions for the present.
  5. Cognitive overload: Human beings have limited mental resources. Will-power and attention are important cognitive resource. In face of uncertainties financial decisions place high demand on these resources and these are quickly exhausted. Under these conditions decision quality suffers because decisions get driven by emotional impulses and short term view of the situation.
  6. Power of framing effects: How a situation is presented to an investor might have major impact on his decision. The format that looks most informative and thus best suited for a financial expert may not help non-experts to arrive at good decision. For example, the quarterly balance sheet published by firms in newspapers is hardly of any use for general investors. Another example can be in the style of presentation by insurance firms and offers for new shares. Often only selective information arranged in a particular way is presented to investor who may get misguided and make inferior decisions.
  7. Overconfidence: As human beings we overestimate our own abilities and skills. We have a tendency to forget and thus we fail to learn from our past mistakes which compound the problem.
  8. Theory of cognitive dissonance: It states that people experience anxiety and internal tension when exposed to conflicting beliefs. Individuals try to reduce their inner conflicts either by changing their past values, beliefs and opinions or they try to rationalize their choice.

In summing up we can say that it is important for the MBA aspirant to understand behavioral aspect of financial planning and decision making. It would help him to make better choice of MBA College and course, depending on ROI rather than getting influenced by friends and other people around him. He would not just base his decision on the advertisements; rather will look far into the future. Also, since going forward he would be taking up managerial and senior positions in the corporate world; he is expected to understand how his behavioral aspects are impacting his decision making for the firm. It would help him make rational decisions which are in the best interest of shareholders.

Contributed By :  Sumit Gulati (Class of 2009, IBS Hyderabad)

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