Behavioural Finance: Reflexive and Reflective Processes in Investment Decisions

Introduction The traditional finance theory has been based on the assumption that an investor is a rational being who takes decisions based on full information to maximize his utility. This classical model assumes the market participants are perfectly and fully informed and can make objective decisions in a logical manner for the efficient functioning of financial markets. In practice, however, empirical studies find that investors make irrational investment decisions due to psychological biases, emotions, and cognitive limitation. This area is in the center of Behavioural finance because it deals with the issue of how psychological elements can influence investment decisions and their implications for market results. Behavioural finance argues against the assumptions of perfect rationality and those of market efficiency. One more crucial conceptual distinction in this space is reflexive versus reflective thinking, two forms of cognition that describe investor behaviour. Reflexive thinking is automatic, fast, and frequently emotive; reflective thinking is slower, more deliberative, and analytical. A basic understanding of these two forms of thinking can prove useful in understanding how investors arrive at decisions, to what kinds of biases they are subject, and how markets perform in the real world. This article covers the area of Behavioural finance, showing the interaction of reflexive and reflective processes that constitute investment choices. The article should therefore give an overview of the two modes of thinking, how they influence the psyche of an investor, and how these eventually drive market anomalies and inefficiency. 1. Behavioural Finance Behavioural finance is integration of psychology with finance for the purpose of understanding of how investors make decisions as well as how such decision may lead to outcomes other than one predicted by traditional financial theories. It recognizes that investors not often rational and are usually subject to biases, emotion, and cognitive limitations causing systematic errors in decisions therefore markets may be diverted off the efficient or equilibrium state. The main biases studied are as follows in behavioural finance: Overconfidence bias: The investor overestimates his or her knowledge or ability for predicting movements of the market. Loss aversion: A loss makes an investor more uneasy than any equivalent gain results in suboptimal risk taking. Anchoring : Overemphasis on that first piece of information when it happens before him which may be pertinent or may not. Herd behaviour: Investors imitate the actions of others and create a bubble and then eventually cause a crash. The above biases are used to explain how they influence an individual\'s investment Behaviour, market prices, and in financial decision-making. 2. Reflexive Thinking in Investment Decisions Reflexive thinking is the intuitive, automatic, and emotional response of the investors who make impulsive judgments without proper