Assignment 1
Prepared by
Swastika Budhathoki
Roll Number: 207025
Registration Number: 027471-20
Submitted to
Mr. Prajol Joshi
Faculty of Behavioral Finance
Kathmandu University School of Management
In partial fulfillment of the requirements for the degree of
Bachelors of Business Administration Emphasis/Honors
Kathmandu, Nepal
25th March, 2024
Write 2-3 pages (not more than 1000 words) short note on:
Background on the concept of behavioral finance (How the discussion on topic start?)
Your understanding of behavioral finance?
How do you see it shaping financial decision-making?
In your view, relevance of the topic in today's financial world?
Rather than using theoretical definition, write in your own words, your own critical analysis on
the topic, present the arguments as necessary and provide reference for all the arguments you are
making. (Provide citation/references as required).
Background
In every way, I question whether asset markets behave as they should. Coming across, different
theories like EMH, CAPM, and finally behavior finance has greatly impacted the way we think. It
compelled us to think that cognitive biases play a vital role in decision-making.
For decades, the world of finance operated under the assumption of rationality, guided by the
principles of the Efficient Market Hypothesis (EMH), which demonstrates that markets are
efficient and that no one can consistently beat them. The stock price fully reflects the publicly
known information. Also, Individuals tend to have self-control and can make decisions without
any biases.
However, the emergence of behavioral finance, Amos Tversky, Daniel Kahneman, and Robert
Shiller, has reshaped our understanding of financial decision-making. Instead of being purely
rational and calculating risk and return, individuals often make decisions influenced by emotions
and cognitive biases. The investors are treated as “normal”, have limits to their self-control, are
influenced by their own biases, and make cognitive errors that can lead to wrong decisions in
behavioral finance. Most importantly, behavioral finance gives importance to two terms i.e. hope
and fear. These two human behaviors determine whether the investors are risk-takers or not.
Hence, Behavioral finance helps to explain the difference between expectations of efficient,
rational investor behavior and actual behavior. (Veni, Rajani, 2020). This paradigm shift
challenges traditional finance theories and highlights the importance of understanding human
behavior in investment decisions.
How do you see behavioral finance in shaping financial decision-making?
Behavioral finance immensely shapes the decision-making process as it incorporates cognitive
biases. It acknowledges that investors are not always rational decision-makers. Biases such as herd
mentality, overconfidence, and anchoring biases can lead to market inefficiencies and mispricing
of assets. Noise traders also, play a vital role in the financial market. In Nepal, the number of noise
traders exceeds the rational investors in the capital market. Irrespective of being in a better position
than last year, NEPSE is still not performing well. All credit goes to the investors’ perspective as
the investors are pessimistic as of now. In Nepal, fundamentals have changed but not the
psychology.
Furthermore, the proportion of noise traders in Nepal is huge which has altered the rational
outcome. This is because Nepali investors trade in three ways based on news, emotions and based
on investor’s mimicry. Hence, we should recognize and understand these biases, so that investors
can make more informed decisions, reducing the likelihood of falling prey to irrational behavior.
In your view, relevance of the topic in today's financial world?
The volume of information available to investors is overwhelming. This inflow of data can
intensify cognitive biases, making it crucial to address behavioral tendencies in financial decision-
making. The dot com bubble and the 2008 financial crisis serve as reminders of the impact of herd
behavior and overconfidence on market dynamics. Another prime example is the Meme Stock
Frenzy also known as GameStop Saga. The surge in demand was primarily driven by online hype
rather than a deep dive into the companies' fundamentals. All these psychological disruptions
significantly affect the financial market as a whole. In a way, manipulation and wrongly perceived
information divert the market into crisis. So, by integrating insights from behavioral finance,
policymakers and investors can better navigate volatile markets and promote financial stability.
Effective decision-making in the stock market goes beyond financial analysis; it requires an
understanding of market psychology and human nature. Cognitive psychology plays a vital role in
shaping investor behavior, emphasizing the importance of emotional discipline in achieving
rational outcomes. In the words of Warren Buffet, “It is only when you combine sound intellect
with emotional discipline that you get rational behavior” (Parikh, 2011).
While traditional finance theories provide a framework for understanding market dynamics,
behavioral finance offers a more detailed perspective by incorporating human behavior into the
equation. By combining these approaches, investors can influence the strengths of both disciplines
to make more robust investment decisions.
In my opinion, behavioral finance sheds light on the limitations of traditional finance and has huge
relevance in today’s world. It incorporates human behavior, the factor no one should miss while
investing or making decisions.
References
Parikh, Parag. 2011. Value Investing and Behavioral Finance. New Delhi: Tata Mcgraw Hill.
Burton, E. T. & Shah, S. N., (2013). Behavioral Finance: Understanding the Social, Cognitive,
and Economic Debates. New Jersey: Wiley
P.Veni, Rajani Kandregula., (2020), Evolution of Behavioral Finance
https://www.ijsdr.org/papers/IJSDR2003039.pdf
