Introduction

Behavioral finance
• Behavioral finance is the study of the effects of psychology on investors
and financial markets.
• It focuses on explaining why investors often appear to lack self-control,
act against their own best interest, and make decisions based on personal
biases instead of facts.
 Introduction
• Since the mid-1950s, the field of finance has been dominated by the traditional
finance model developed by the economists of the University of Chicago
• Behavioural finance was considered first by the psychologist Daniel Kahneman and
economist Vernon Smith
• Behavioural finance is a concept developed with the inputs taken from the field of
psychology and finance.
• Behavioural finance is defined as the study of the influence of socio-psychological
factors on an asset’s price. It focuses on investor behaviour and their investment
decision-making process.
• Behavioural Finance (BF) is the study of investors’ psychology while making financial decisions.
• It is the study of the influence of psychology and sociology on the behaviour of financial
practitioners and the subsequent effect on market.
• According to Behavioural finance, investors’ market behaviour derives from psychological
principles of decision-making to explain why people buy or sell stock.
• Behavioural finance focuses upon how investor interprets and acts on information to take various
investment decisions.
• Behavioural finance can be explained as modern finance in which it seeks the reasons of stock
market anomalies by justifying them with explanation of various biases that the investor has
while taking investment decisions.
• Behavioural finance is an add-on paradigm of finance, which seeks to supplement the standard
theories of finance by introducing behavioural aspects to the decision-making process.
• Behavioural finance deals with individuals and ways of gathering and using information. At
its core, behavioural finance analyses the ways that people make financial decisions.
• Behavioural finance seeks to understand and predicts systematic financial market implications
of psychological decision processes.
• it focused on the application of psychological and economic principles for the improvement of
financial decision- making.
• Behavioural finance is the combination of psychology, sociology and finance.
• Behavioural finance is the integration of classical economics and finance
with psychology and the decision making sciences
• Behavioural finance is an attempt to explain what causes some of the
anomalies that have been observed and reported in the finance literature.
• Behavioural finance is the study of how investors systematically make
errors in judgment or ‘mental mistakes’.
• Behavioural finance is defined as the field of finance that proposes
psychological based theories to explain stock market anomalies.
 NATURE OF BEHAVIOURAL FINANCE

• Behavioural finance is not just a part of finance but is broader and wider in
scope and includes insights from Behavioural economic, psychology and
microeconomic theory
• In the process of making financial investments, investors often have difficulty
while choosing the most economic option because of the impact of his/her
various psychological and mental filters.
• When an investor asks for guidance from an agent or a professional in the field
of finance, their behaviour may also be influenced by market information or
strategies of other agents or professionals.
• Behavioural finance can be defined as open-minded finance. The main theme of traditional
finance is to avoid all possible effects of the personality and mindset of an individual.
• But anomalies and biases existing in the real world are explained with the help of
behavioural finance to explain the reasons for the same. As per standard finance theories,
investors should be rational in their approach but behavioural finance helps in explaining
the normal behaviour of investors.
• Behavioural finance focuses on the reasons that limit the theories of standard finance and
also the reasons for market anomalies created.
SCOPE OF BEHAVIOURAL FINANCE

• To understand the reasons of market anomalies standard finance theories are able to
justify the stock market to a great extent, still there are many market anomalies that take
place in stock markets, including creation of bubbles, the effect of any event, calendar
effect on stock market trade etc.
• These market anomalies remain unanswered in standard finance but behavioural finance
provides explanation and remedial actions to various market anomalies.
• To identify investor’s personality: An exhaustive study of behavioural finance helps in
identifying the different types of investor personality. Once the biases of the investor’s
actions are identified, by the study of investor’s personality, various new financial
instruments can be developed to hedge the unwanted biases created in the financial markets
• To enhance the skill set of investment advisors: This can be done by
providing better understanding of the investor’s goals, maintaining a
systematic approach to advise, earn the expected return and maintain a
win-win situation for both the client and the advisor.
• Helps to identify the risks and develop hedging strategies: Because of
various anomalies in the stock markets, investments these days are not
only exposed to the identified risks, but also to the uncertainty of the
returns.
• To review the debatable issues in standard finance and to protect the
interests of stakeholders in volatile investment scenario.
• To examine the relationship between theories of standard finance and
Behavioural finance and to analyse the influence of biases on the
investment process because of different personalities playing in the
investment market.
• To examine the various social responsibilities of the subject.
• To discuss emerging issues in the financial world.
• To discuss the development of new financial instruments, which have been developed
because of the need of hedging the conventional instruments against various market
anomalies.
• To familiarize themselves with trend of changes over the years across various
economies.
• To examine the contagion effect of various events.
• An effort towards more elaborated identification of investor’s personality.
• More elaborate discussions on optimum asset allocation according to age, sex, income
and unique personality of investors.
APPLICATION OF BEHAVIOURAL FINANCE

• Behavioural finance actually equips finance professionals with a set of new lenses, which allows
them to understand and overcome many proven psychological traps that are present involving
human cognition and emotions.
• Behavioural traps exist and occur across all decision spectrums because of the psychological
phenomena of heuristics and biases. It applies to
• Investors
• Corporations
• Markets
• Regulators
• Educations
• Behavioural finance, as a subject, can be better discussed if we divide it
into two branches which are as follows:
• Micro Behavioural Finance
• Macro Behavioural Finance
• Micro Behavioural Finance (BFMI): This branch deals with the behaviour of
individual investors. In BFMI, we compare irrational investors to rational investors,
as observed in the rational/classical economic theory. These rational investors are
also known as “homo economicus” or the rational economic man.
 Macro Behavioural Finance (BFMA):
• Unlike micro behavioural finance (BFMI), which deals with the behaviour
of individuals, macro behavioural finance deals with the drawbacks of the
efficient market hypothesis. Efficient market hypothesis is one of the
models in conventional finance that helps us understand the trend of
financial markets. Macro behavioural finance also addresses the
limitations of Portfolio Principles of Markowitz, the Capital Asset Pricing
Model (CAPM), Theory of Sharpe, Linter, Black and the Option- Pricing
Theory of Black, Scholes and Merton
 Behavioural Finance as a Science
• Whether behavioural finance should be regarded as a science or not
depends on how we define science. To put it simply, science is a
systematic and scientific way of (i) observing, (ii) recording, (iii)
analysing and (iv) interpreting any event.
 Behavioural Finance as an Art
• Behavioural finance provides various tailor-made solutions to the
investors to be applied in their financial planning, hence it can be justified
as an art of finance in a more practical manner.
Behavioural Biases that Influence Investment Decisions

Denial: Most of the times investors do not want to believe that the stock they have held since ages
has become under-performing or they need to sell it off. They are in a constant state of denial.
Even through the said asset brings the overall return of the portfolio down, investors are reluctant
to part with it.
Information processing errors: Often referred to as the heuristic simplification, information-processing error
is one of the biases of investor psychology. These people use the simplest approach to solve a problem rather
than depending on logical reasoning. Heuristic simplification can be detrimental to the investing decisions. This
is done by omitting crucial information to reduce complexity and processing only part information. Such an
approach can lead to flawed decisions which can be dangerous to the stock market.
• Emotions: Most of the behavioural anomalies stem from extreme emotions of the investors.
This happens when investors do not make decisions with an objective mind and only tend to
respond to their biases. Misconceptions, misinterpretations, risk-aversion, past experiences all combine to
block the logical bent of mind and exposes the investment decisions to possibilities of risk and losses.
• Loss Aversion: The risk-taking ability of each investor is different. Some are conservative in their approach
while others believe in taking calculated risks. However, among the conservative investors are few who fear
losses like anything. They may be aware about the potential gains from an asset class but are intimidated by
the prospects of incurring even a short-term loss. In short, their excitement for gains is much less than their
aversion towards losses. Needless to say these investors miss out on quite a few fruitful investments.
• Social influence/herd mentality: Herding is quite an infamous phenomenon in the stock markets and is the
result of massive sell offs and rallies. These investors do not put in deep research behind their decisions and
only follow the sentiment of the crowd whether positive or negative. Whether it was the tech-bubble in the
early 90s, the subprime crisis in 2008, the Eurozone crisis in 2010 or the recent banking sector scams in
India, the market has seen huge sell-offs. Most of them weren’t even warranted.
• Framing: According to the Modern Portfolio Theory, an investment cannot be evaluated in
isolation. It has to be viewed in the light of the entire portfolio. Instead of focusing on individual
securities, investors should have a broader vision of wealth management. However, there are
investors who single out assets or a particular investment for evaluation. This is viewing at
things through a “narrow frame”. This may lead to losses. Investors need to look at the holistic
picture and evaluate with a “wider frame”.
• Anchoring: Many a time investors hold on to a particular belief and refuse to part ways with it. They
“anchor” their beliefs to that notions and have difficulty in accepting any new piece of information related to
the subject. This is true in cases wherein a real estate or pharmaceutical company is involved in a legal battle
or bank has been involved in a scam. This negative information is received with greater intensity, so much so
that no other piece of positive information can neutralize its effect.
• Behavioural finance advocates two approaches to decision-making:
• Reflexive – Following your gut feeling and inherent beliefs. In fact this is your default option.
• Reflective – This approach is logical and methodical, something that requires a deep thought process.
• The more investors rely on reflexive decision-making, the more exposed they are to behavioural
biases like self-deception biases, heuristic simplification, excess emotions and herding. Behavioural
finance is an in depth study on these patterns and is creating a crucial place for itself among investors
and investment managers.
• To mitigate against reflexive decision-making, it’s important to set up processes. Consider setting up
processes that guide you through a logical decision- making approach and therefore help mitigate the
use of reflexive decision making.
 The key difference between “Traditional
Finance” and “Behavioural Finance”
• Traditional finance presupposes that people view all decision through the
transparent and objective lens of risk and return. Put differently, the form
(or frame) used to describe a problem is inconsequential. In contrast,
behavioural finance postulates that perceptions of risk and return are
significantly influenced by how decision problem is framed. In other
words, behavioural finance assumes frame dependence.
• Traditional finance argues that markets are efficient, implying that the price of each
security is an unbiased estimate of its intrinsic value. In contrast, behavioural finance
contends that heuristic-driven biases and errors, frame dependence, and effects emotions
and social influence often lead to discrepancy between market price and fundamental
value.
• Traditional finance views that price follow random walk, though prices fluctuate to
extremes, they are brought back to equilibrium in time. While behavioural finance views
that prices are pushed by investors to unsustainable levels in both direction. Investor
optimists are disappointed and pessimists are surprised. Stock prices are future estimates,
a forecast of what investors expect tomorrow’s price to be, rather than an estimate of the
present value of future payment streams
• Traditional finance assumes that people are guided by reasons and logic
and independent judgment. While, behavioural finance, recognises that
emotions and herd instincts play an important role in influencing decisions
• Traditional finance assumes that people process data appropriately and
correctly. In contrast, behavioural finance recognises that people employ
imperfect rules of thumb (heuristics) to process data which induces biases
in their belief and predisposes them to commit errors.
THE RISE OF THE RATIONAL MARKETS HYPOTHESIS

• Modern corporate finance

• Portfolio theory and capital asset pricing model
• Random walk and efficient markets hypothesis
 Modern Corporate Finance
• : Until the late 1950s, finance was taught in business schools as a mix of common sense,
institutional practices, judgment, and tradition that had very little to do with economics.
• This separation could be traced to the philosophy of Harvard Business School, set up in
1908, where its founding fathers were convinced that the new school should emphasise
the practical, eschew academic theories, and rely on “case method” of teaching which it
imported from Harvard Law School.
• Things, however, began changing in the late 1950s. The task of reshaping the study of
finance in the image of modern mathematical economics was begun by two conventional
economists, Franco Modigliani and Merton H. Miller
 Portfolio Theory and Capital Asset
Pricing Model
• the use of mathematical and statistical theory for decision making— originated in
the 1930s in the United Kingdom to solve military problems. It soon spread across
the Atlantic and played a crucial role in helping the Allies win World War II. After
the end of the war, operations research (OR) efforts were directed to peacetime uses,
such as stock market investing
• In 1952, Harry Markowitz, a graduate student at Chicago, published his landmark
paper in which he developed an approach to portfolio selection that optimally
balanced risk and return and laid the foundation for a new, quantitative approach to
finance. Harry Markowitz developed an approach that helps an investor to achieve
his optimal portfolio position
• William Sharpe and others asked the follow-up question: If rational
investors follow the Markowitzian prescription, what kind of relationship
exists between risk and return? Essentially, the capital asset pricing model
(CAPM) developed by them is an exercise in positive economics. It is
concerned with two key questions:
• What is the relationship between risk and return for an efficient portfolio?
• What is the relationship between risk and return for an individual security?
• The CAPM, in essence, predicts the relationship between the risk of an
asset and its expected return. This relationship is very useful in two
important ways. First, it produces a benchmark for evaluating various
investments. For example, when we are analysing a security we are
interested in knowing whether the expected return from it is in line with
its fair return as per the CAPM. Second, it helps us to make an informed
guess about the return that can be expected from an asset that has not yet
been traded in the market.
• . For example, how should a firm price its initial public offering of stock?
Although the empirical evidence on the CAPM is mixed, it is widely used
because of the valuable insight it offers and its accuracy is deemed
satisfactory for most practical applications. No wonder, the CAPM is a
centerpiece of modern financial economics .
Random Walk and Efficient Markets
Hypothesis
• Maurice Kendall, a distinguished statistician, presented a somewhat unusual paper before
the Royal Statistical Society in London. Kendall examined the behaviour of stock and
commodity prices in search of regular cycles.
• Instead of discovering any regular price cycle, he found each series to be “a wandering
one, almost as if once a week the Demon of Chance drew a random number… and added
it to the current price to determine the next week’s price.”
• Put differently, prices appeared to follow a random walk, implying that successive price
changes are independent of one another.
• A random walk means that successive stock prices are independent and identically
distributed. Therefore, strictly speaking, the stock price behaviour should be
characterised as a submartingale, implying that the expected change in price can be
positive because investors expect to be compensated for time and risk. Further, the
expected return may change over time in response to change in risk.
• Inspired by the works of Kendall, Roberts, and Osborne, a number of researchers
employed ingenious methods to test the randomness of stock price behaviour. By
and large, these tests have vindicated the random walk hypothesis. Indeed, in terms
of empirical evidence, very few ideas in economics can rival the random walk
hypothesis.