Behavioral Finance
Introduction
Traditional Finance assumes rationality:
Individuals act rationally.
Markets are efficient.
Behavioral Finance challenges this:
Psychology influences financial decisions.
Investors can be irrational due to cognitive mistakes and
emotional biases.
Behavioral Finance: Studies the influence of personal
and social psychology on financial decisions.
Meaning of Behavioral Finance
The study of investors' psychology when making
financial decisions is known as behavioural
finance.
It focuses on explaining
why investors often appear to lack self-control,
act against their own best interest,
make decisions based on personal biases instead
of facts.
Definitions of behavioral finance
Sewell:
"Study of the influence of psychology on the behavior of
financial practitioners and the subsequent effect on markets."
Shefrin:
"Application of psychology to financial behavior – the behavior
of investment practitioners."
Lintner G:
A study of humans interpreting and acting on information to
make informed investment decisions.
Belsky and Gilovich:
Combining psychology and economics to explain irrational
decisions about saving, investing, spending, and borrowing
Scope of Behavioral Finance
Understanding Market Anomalies: Bubbles,
event effects, calendar effects.
Identifying Investor Personality: Creating
tailored financial instruments.
Enhancing Investment Advisor Skills:
Understanding investor goals and maintaining a
systematic approach.
Identifying Risks and Developing Hedging
Strategies: Addressing uncertainties in returns.
Characteristics of Behavioral Finance
• Framing:
– Decision-makers perception of a problem and its outcomes.
– Affected by presentation and personal perception.
• Heuristics:
– "Rules of thumb" developed through experience.
– Can lead to errors like anchoring and representativeness.
• Emotions:
– Driven by needs, desires, and fears.
– Influence investor choices and shape financial markets.
• Impact on Market:
– Market prices may not always be fair.
– Correlated cognitive errors can affect market prices.
Behavioral Considerations for Investors
• Biases and heuristics apply to all.
• Awareness on emotions to be controlled.
• Information Accuracy:
– Increasing information may not increase forecast
accuracy.
– Don't confuse familiarity with knowledge.
• Focus on Facts:
– Base decisions on facts, not prices.
Contd…
• Overcoming Loss Aversion:
– Sell losing investments and learn from mistakes.
• Information Evaluation:
– Consider how information is presented.
– Avoid projecting immediate events into the future.
• Emotional Control:
– Be aware of herd investing and mental accounting.
• Investment Horizon:
– Don't try to get rich quickly; diversify and minimize
trading.
Applications of Behavioral Finance
• CAPM and EMH assume rationality, but anomalies exist.
• Behavioral Finance explains:
Why individuals don't always make expected decisions.
Why markets don't always behave as expected.
• Helps avoid emotion-driven speculation.
• Devises appropriate wealth management strategies
• Understanding market anomalies (bubbles, crashes).
• Improving investment decision-making.
• Developing better financial products and services.
• Enhancing the skills of investment advisors.
• Wealth Management Strategies
Key Theories
• Framing
• Heuristics
• Emotions
• Biases
Framing Theory
Definition:
How the presentation of information influences decisions,
even when the objective facts remain the same.
Example:
Presenting an investment as a "90% chance of success"
vs. a "10% chance of failure.“
Impact:
Investors may react differently based on how the same
information is framed.
Heuristics Theory
Definition:
Mental shortcuts or "rules of thumb" used to make
decisions quickly.
Types of Heuristics:
– Anchoring: Over-reliance on initial information.
– Representativeness: Judging probabilities based on stereotypes.
– Availability: Overestimating the importance of readily available
information.
Impact:
Can lead to systematic errors in judgment.
Emotions Theory
Definition:
The influence of emotions (fear, greed,
overconfidence, regret) on investment
decisions.
Impact:
– Can cause investors to act irrationally, such as
buying high and selling low.
– Leads to herd behavior (following the crowd).
Common Behavioral Biases
•Herding:
• Overconfidence: Definition:
Definition: Following the actions of a group,
Exaggerated belief in one's own abilities. even if they are irrational.
Impact: Impact:
Excessive trading and under-diversification. Market bubbles and crashes.
• Loss Aversion: •Mental Accounting:
Definition: Definition:
Feeling the pain of a loss more strongly than Treating different pots of money
the pleasure of an equivalent gain. differently.
Impact: Impact:
Holding onto losing investments for too long. Can lead to irrational spending and
• Confirmation Bias: investment decisions.
Definition:
Seeking out information that confirms pre-
existing beliefs.
Impact:
Ignoring contradictory information and
making biased decisions.
