What Is Behavioral

Finance?
 Behavioral finance
Behavioral finance, commonly
defined as the application of
psychology to finance, has become a
very hot topic, generating new
credence with the. Additional
confusion may arise from a
proliferation of topics resembling
behavioral finance, at least in name,
including behavioral science, investor
psychology, cognitive psychology,
behavioral economics, experimental
economics, and cognitive sciences.
 Behavioral finance
Itshould be noted that there is
an entire body of information
available on what the popular
press has termed “the
psychology of money.” This
subject involves individuals’
relationship with money—how
they spend it, how they feel
about it, and how they use it.
 Behavioral finance
 Perhaps the greatest realization of
behavioral finance as a unique academic
and professional discipline is found in the
work of Daniel Kahneman and Vernon Smith,
who shared the Bank of Sweden Prize in
Economic Sciences in Memory of Alfred
Nobel 2002. The Nobel Prize organization
honored Kahneman for “having integrated
insights from psychological research into
economic science, especially concerning
human judgment and decision-making under
uncertainty.” Smith similarly “established
laboratory experiments as a tool in empirical
economic analysis, especially in the study of
alternative market mechanisms,” garnering
the recognition of the committee.
 Behavioral finance
 ProfessorKahneman found that under conditions
of uncertainty, human decisions systematically
depart from those predicted by standard
economic theory. Kahneman, together with Amos
Tversky formulated prospect theory. An
alternative to standard models, prospect theory
provides a better account for observed behavior
and is discussed at length in later chapters.
Kahneman also discovered that human judgment
may take heuristic shortcuts that systematically
diverge from basic principles of probability. His
work has inspired a new generation of research
employing insights from cognitive psychology to
enrich financial and economic models. Vernon
Smith is known for developing standards for
laboratory methodology that constitute the
foundation for experimental economics
 Behavioral finance
 ProfessorKahneman found that under conditions
of uncertainty, human decisions systematically
depart from those predicted by standard
economic theory. Kahneman, together with Amos
Tversky formulated prospect theory. An
alternative to standard models, prospect theory
provides a better account for observed behavior
and is discussed at length in later chapters.
Kahneman also discovered that human judgment
may take heuristic shortcuts that systematically
diverge from basic principles of probability. His
work has inspired a new generation of research
employing insights from cognitive psychology to
enrich financial and economic models. Vernon
Smith is known for developing standards for
laboratory methodology that constitute the
foundation for experimental economics
 Behavioral Finance Micro
versus Behavioral Finance
Macro
Behavioral Finance Micro (BFMI)
examines behaviors or biases of
individual investors that distinguish
them from the rational actors
envisioned in classical economic
theory.
Behavioral Finance Macro (BFMA)
detects and describe anomalies in
the efficient market hypothesis that
behavioral models may explain.
 Behavioral Finance Micro
versus Behavioral Finance
Macro practitioners
As wealth management
and investors, our primary focus will
be BFMI, the study of individual
investor behavior. Specifically, we
want to identify relevant
psychological biases and investigate
their influence on asset allocation
decisions so that we can manage the
effects of those biases on the
investment process.
 The Two Great Debates Of
Standard Finance Versus
Behavioral
 “Standard Finance
finance is the body of knowledge built on
the pillars of the arbitrage principles of Miller and
Modigliani, the portfolio principles of Markowitz, the
capital asset pricing theory of Sharpe, Lintner, and
Black, and the option-pricing theory of Black,
Scholes, and Merton.”8 Standard finance theory is
designed to provide mathematically elegant
explanations for financial questions that, when
posed in real life, are often complicated by
imprecise, inelegant conditions. The standard
finance approach relies on a set of assumptions
that oversimplify reality. For example, embedded
within standard finance is the notion of “Homo
Economicus,” or rational economic man. It
prescribes that humans make perfectly rational
economic decisions at all times. Standard finance,
basically, is built on rules about how investors
“should” behave, rather than on principles
describing how they actually behave.
The Two Great Debates Of
Standard Finance Versus
Behavioral Finance
 Efficient Markets versus
Irrational Markets
 During the 1970s, the standard finance
theory of market efficiency became the
model of market behavior accepted by
the majority of academ ics and a good
number of professionals. The Efficient
Market Hypothesis had matured in the
previous decade, stemming from the
doctoral dissertation of Eugene Fama.
Fama persuasively demonstrated that
in a securities market populated by
many well-informed investors,
investments will be appropriately priced
and will reflect all available information.
 Efficient Markets versus
Irrational Markets
 There are three forms of the efficient
market hypothesis:
 1. The “Weak” form contends that all
past market prices and data are fully
reflected in securities prices; that is,
technical analysis is of little or no value.
 2. The “Semistrong” form contends that
all publicly available information is fully
reflected in securities prices; that is,
fundamental analysis is of no value.
 3. The “Strong” form contends that all
information is fully reflected in
securities prices; that is, insider
information is of no value..
 Efficient Markets versus
Irrational Markets
 An efficient market can basically be defined
as a market wherein large numbers of
rational investors act to maximize profits in
the direction of individual securities. A key
assumption is that relevant information is
freely available to all participants. This
competition among market participants
results in a market wherein, at any given
time, prices of individual investments reflect
the total effects of all information, including
information about events that have already
happened, and events that the market
expects to take place in the future. In sum,
at any given time in an efficient market, the
price of a security will match that security’s
intrinsic value
 Efficient Markets versus
Irrational Markets
The implications of the efficient market
hypothesis are far-reaching. Most
individuals who trade stocks and bonds
do so under the assumption that the
securities they are buying (selling) are
worth more (less) than the prices that
they are paying. If markets are truly
efficient and current prices fully reflect
all pertinent information, then trading
securities in an attempt to surpass a
benchmark is a game of luck, not skill.
Efficient Markets versus
Irrational Markets
 Efficient Markets versus
Irrational Markets
 Fundamental Anomalies. Irregularities
that emerge when a stock’s performance
is considered in light of a fundamental
assessment of the stock’s value are
known as fundamental anomalies. Many
people, for example, are unaware that
value investing—one of the most popular
and effective investment methods—is
based on fundamental anomalies in the
efficient market hypothesis. There is a
large body of evidence documenting that
investors consistently overestimate the
prospects of growth companies and
underestimate the value of out-of-favor
companies.
 Efficient Markets versus
Irrational Markets
Technical Anomalies. Another major
debate in the investing world revolves
around whether past securities prices
can be used to predict future
securities prices. “Technical analysis”
encompasses a number of techniques
that attempt to forecast securities
prices by studying past prices.
Sometimes, technical analysis reveals
inconsistencies with respect to the
efficient market hypothesis; these are
technical anomalies
 Efficient Markets versus
Irrational Markets
Calendar Anomalies. One calendar
anomaly is known as “The January
Effect.” Historically, stocks in general
and small stocks in particular have
delivered abnormally high returns
during the month of January. Robert
Haugen and Philippe Jorion, two
researchers on the subject, note that
“the January Effect is, perhaps, the best-
known example of anomalous behavior
in security markets throughout the
world.”
 Rational Economic Man
versus Behaviorally Biased
Stemming fromMan
neoclassical
economics, Homo economicus is a
simple model of human economic
behavior, which assumes that
principles of perfect self-interest,
perfect rationality, and perfect
information govern economic
decisions by individuals. Like the
efficient market hypothesis, Homo
economicus is a tenet that
economists uphold with varying
degrees of stringency
 Rational Economic Man
versus Behaviorally Biased
 Economists like to Man
use the concept of
rational economic man for two primary
reasons: (1) Homo economicus makes
economic analysis relatively simple.
Naturally, one might question how useful
such a simple model can be. (2) Homo
economicus allows economists to quantify
their findings, making their work more
elegant and easier to digest. If humans are
perfectly rational, possessing perfect
information and perfect selfinterest, then
perhaps their behavior can be quantified.
Most criticisms of Homo economicus proceed
by challenging the bases for these three
underlying assumptions—perfect rationality,
perfect self-interest, and perfect information.
 Rational Economic Man
versus Behaviorally Biased
Man
 Perfect Rationality. When humans are
rational, they have the ability to reason and
to make beneficial judgments. However,
rationality is not the sole driver of human
behavior. In fact, it may not even be the
primary driver, as many psychologists
believe that the human intellect is actually
subservient to human emotion. They
contend, therefore, that human behavior is
less the product of logic than of subjective
impulses, such as fear, love, hate, pleasure,
and pain. Humans use their intellect only to
achieve or to avoid these emotional
outcomes.
 Rational Economic Man
versus Behaviorally Biased
Man Many studies
Perfect Self-Interest.
have shown that people are not
perfectly self-interested. If they were,
philanthropy would not exist. Religions
prizing selflessness, sacrifice, and
kindness to strangers would also be
unlikely to prevail as they have over
centuries. Perfect self-interest would
preclude people from performing such
unselfish deeds as volunteering, helping
the needy, or serving in the military.
 Rational Economic Man
versus Behaviorally Biased
Man Some people
Perfect Information.
may possess perfect or near-perfect
information on certain subjects; a doctor
or a dentist, one would hope, is
impeccably versed in his or her field. It
is impossible, however, for every person
to enjoy perfect knowledge of every
subject. In the world of investing, there
is nearly an infinite amount to know and
learn; and even the most successful
investors don’t master all disciplines
 How Practical Application Of Behavioral
Finance Can Create A Successful Advisory
Relationship
 Wealth management practitioners have
different ways of measuring the success of
an advisory relationship. Few could argue
that every successful relationship shares
some fundamental characteristics:
 ■ The advisor understands the client’s
financial goals.
 ■ The advisor maintains a systematic
(consistent) approach to advising the client.
 ■ The advisor delivers what the client
expects.
 ■ The relationship benefits both client and
advisor. So, how can behavioral finance
help?
 Rational Economic Man
Rational economic man (REM) describes
a simple model of human behavior. REM
strives to maximize his economic well-
being, selecting strategies that are
contingent on predetermined, utility-
optimizing goals, on the information
that REM possesses, and on any other
postulated constraints. The amount of
utility that REM associates with any
given outcome is represented by the
output of his algebraic utility function.
 Rational Economic Man
Some psychological researchers argue
that Homo economicus disregards inner
conflicts that real people face. For
instance, Homo economicus does not
account for the fact that people have
difficulty prioritizing short-term versus
long-term goals (e.g., spending versus
saving) or reconciling inconsistencies
between individual goals and societal
values. Such conflicts, these researchers
argue, can lead to “irrational” behavior.
MODERN BEHAVIORAL
FINANCE
 By the early twentieth century, neoclassical
economics had largely displaced psychology as an
influence in economic discourse. In the 1930s and
1950s, however, a number of important events laid
the groundwork for the renaissance of behavioral
economics. First, the growing field of experimental
economics examined theories of individual choice,
questioning the theoretical underpinnings of Homo
economicus. Some very useful early experiments
generated insights that would later inspire key
elements of contemporary behavioral finance.
MODERN BEHAVIORAL
FINANCE
 In order to understand why economists began
experimenting with actual people to assess the
validity of rational economic theories, it is necessary
to understand indifference curves. The aim of
indifference curve analysis is to demonstrate,
mathematically, the basis on which a rational
consumer substitutes certain quantities of one good
for another.
 An indifference curve is a line that depicts all of the
possible combinations of two goods between which a
person is indifferent; that is, consuming any bundle
on the indifference curve yields the same level of
utility the work-versus-leisure model, for example,
workers may not allocate any sum exceeding 24
hours per day.
MODERN BEHAVIORAL
FINANCE
MODERN BEHAVIORAL
FINANCE
Allais made distinguished, pioneering, and
highly original contributions in many areas of
economic research he is perhaps best known
for his studies of risk theory and the so-called
Allais paradox. He showed that the theory of
maximization of expected utility, which had
been accepted for many decades, did not
apply to certain empirically realistic decisions
under risk and uncertainty. In the Allais
paradox, Allais asked subjects to make two
hypothetical choices. The first choice was
between alternatives “A” and
“B,” defined as:
MODERN BEHAVIORAL
FINANCE
In the Allais paradox, Allais asked
subjects to make two hypothetical
choices. The first choice was between
alternatives “A” and “B,” defined as:
A — Certainty of receiving 100
million (francs).
B — Probability .1 of receiving 500
million.
Probability .89 of receiving 100 million.
Probability .01 of receiving zero.
MODERN BEHAVIORAL
FINANCE
C — Probability .11 of earning 100
million.
Probability .89 of earning zero.
D — Probability .1 of earning 500 million.

Probability .9 of earning zero.

It is not difficult to show that an
expected utility maximizer who prefers A
to B must also prefer C to D. However,
Allais reported that A was commonly
preferred over B, with D preferred over C
 Cognitive Psychology
Many scholars of contemporary
behavioral finance feel that the field’s
most direct roots are in cognitive
psychology. Cognitive psychology is the
scientific study of cognition, or the
mental processes that are believed to
drive human behavior. Research in
cognitive psychology investigates a
variety of topics, including memory,
attention, perception, knowledge
representation, reasoning, creativity, and
problem solving.
Decision Making under
Uncertainty
 Facinguncertainty, most people cannot and
do not systematically describe problems,
record all the necessary data, or synthesize
information to create rules for making
decisions. Instead, most people venture
down somewhat more subjective, less ideal
paths of reasoning in an attempt to
determine the course of action consistent
with their basic judgments and preferences.
How, then, can decision making be faithfully
modeled?
Barnewall Two-Way Model
Barnewall noted: “Passive
investors” are defined as those
investors who have become
wealthy passively—for example,
by inheritance or by risking the
capital of others rather than
risking their own capital. Passive
investors have a greater need for
security than they have tolerance
for risk.
Barnewall Two-Way Model
“Active investors” are defined as those individuals who
have earned their own wealth in their lifetimes. They
have been actively involved in the wealth creation, and
they have risked their own capital in achieving their
wealth objectives. Active investors have a higher
tolerance for risk than they have need for security.
Related to their high risk tolerance is the fact that active
investors
prefer to maintain control of their own investments. If
they become
involved in an aggressive investment of which they are
not
in control, their risk tolerance drops quickly. Their
tolerance for
risk is high because they believe in themselves.
Barnewall Two-Way Model
Related to their high risk
tolerance is the fact that active
investors prefer to maintain
control of their own investments.
If they become involved in an
aggressive investment of which
they are not in control, their risk
tolerance drops quickly. Their
tolerance for risk is high because
they believe in themselves.
 Prospect Theory
Cognitive psychologists, Amos
Tversky and Daniel Kahneman,
began research on decision
making under uncertainty. This
work ultimately produced a very
important book published in 1982
entitled Judgment under
Uncertainty: Heuristics and
Biases
 Prospect Theory
The research was sparked by the
realization that intuitive
predictions and judgments under
uncertainty do not follow the laws
of probability or the principles of
statistics