Behavioral economics: effect on business decision making

Abstract

Economics is all about allocating resources, trade-off and making choices. Thus decision making is central to every economic theory. All economic theory assumes a very unrealistic model of human behaviour. The assumptions made on the human behaviour are that individuals have unlimited will power, unlimited rationality and unlimited selfishness. Thus, much of the economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case. Many examples of irrational behaviour and repeated errors in judgement have been documented in academic studies. The science of Behavioural Economics deals with understanding and explaining how certain cognitive errors or biases influence investors in their decision-making process. The proponents of this approach suggest that such biases are often responsible for various irregular phenomena that appear like stock bubbles in financial markets. Using results from cognitive psychology, behavioural economics attempts to shed more light on the nature of these anomalies. In this study, we applied principles from the behavioural finance literature in an attempt to shed light on the question that what are the merits of including inputs from behavioural economics on the effectiveness of a business decision modelling framework. We believe that such a question is of great importance to all the managers, quantitative/financial analysts who have to take various business decisions. This study would serve as a guide to these people by identifying situations which warrants use of behavioural factors and suggesting rational and irrational input variables to be considered for better decision making. We started by understanding the principles of behavioural economics and identified various factors which affect effective decision making. After that we tried to explain already proven anomalies in financial markets using the principles of behavioural economics. We went on to test these hypothesis on Indian markets and devised an innovative trading strategy to exploit these biases to extract superior returns from the financial markets. The results were highly encouraging and prove the fact that markets are indeed irrational.