2. INTRODUCTION TO BEHAVORIAL
FINANCE
A theory of finance that attempts to explain the decisions of investor
by viewing them as rational actors looking out for their self-
interest, given the sometimes inefficient nature of the market.
Combine behavioral and cognitive psychological theory with conventional
economics and finance to provide explanations for why people make
irrational financial decisions.
Combines social and psychological theory with financial theory as a means
of understanding how price movements in the securities markets occur
independent of any corporate actions.
3. NATURE OF BEHAVORIAL FINANCE
Bridge gap between finance and psychology
Two types:
1. Rational finance paradigm
2. Irrational finance paradigm
Rational finance paradigm: investors act rationally and consider all
available information in decision-making process
Irrational finance paradigm: behavior of an individual is determined by
own mind
Stimulating field of scholarship
4. SCOPE OF BEHAVORIAL FINANCE
Inflation and stock market
Underpricing of Initial Public Offering
Investors
Corporations
Markets
Regulations
Education
5. OBJECTIVES OF BEHAVORIAL FINANCE
Correct decision making
Provide knowledge to unaware investors
Identifies emotions and mental errors
Delivering what the client expects
Ensuring mutual benefits
Maintaining a consistent approach
Examining a consistent approach
6. SIGNIFICANCE OF BEHAVORIAL
FINANCE
Determining goals of investors
Defines investors’ biases
Manages behavioural biases
Helps in investment decisions
Helps for financial advisors’ and fund managers
Signifies that investors are emotional
8. PROSPECT THEORY
Developed by Kahneman and Tversky in 1979
Shows how people manage risk and uncertainty
Most central element of prospect theory is S-shaped value function
Value
GainLoss
9. LOSS AVERSION THEORY
People weigh all potential gains and losses in relation to some benchmark
reference point
Depicts tendency of people to show greater sensitivity to losses than gains
Types
1. Loss on the basis of “valence” or desirability
2. Loss on the basis of changes in possession
10. MENTAL ACCOUNTING
People’s tendency to code, categorise and evaluate economic outcomes
Primary reason is to enhance our understanding of the psychology of
choice
3 components
1. Perception of outcomes and the making and evaluation of decisions
2. Assignment of activities to specific accounts
3. Determination of time periods to which different mental accounts relates
11. INVESTORS DISPOSITION EFFECT
Disposition effect: notion of framing to the realization of losses
Refer to asymmetric risk aversion, according to which investors are risk-
averse when faced with gains and risk-seeking when faced with losses
13. NATURE OF PSYCHOLOGY
Study of experience
Study of mental processes
Study of behaviour
14. IMPORTANCE OF PSYCHOLOGY
Helps to identify goals
Helps to understand the investors attitude
Helpful in decision making
Helps to identify the financial market environment
15. PSYCHOLOGY OF FINANCIAL
MARKETS
Offers an understanding of financial market process which goes beyond
cognitive aspects alone
Provides insights into the connection between the subjective experience of
market participants and objective market processes
Offers insight into the difference between market participants
16. PSYCHOLOGY OF INVESTOR
BEHAVIOR
Incorporates both quantitative and qualitative aspect
Examines the mental processes and emotional issues
Different biases
1. Familiarity bias
2. Self-attribution bias
3. Trend-chasing bias
4. Behavorial bias