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What Is Behavioral Finance PDF
What Is Behavioral Finance PDF
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Abstract
While conventional academic finance emphasizes theories such as modern portfolio theory and the efficient market
hypothesis, the emerging field of behavioral finance investigates the psychological and sociological issues that impact
the decision-making process of individuals, groups, and organizations. This paper will discuss some general prin-
ciples of behavioral finance including the following: overconfidence, financial cognitive dissonance, the theory of
regret, and prospect theory. In conclusion, the paper will provide strategies to assist individuals to resolve these “men-
tal mistakes and errors” by recommending some important investment strategies for those who invest in stocks and
mutual funds.
mum (highest) expected return given the amount of Defining the Various Disciplines of Behavioral Finance
risk assumed, or, on the contrary, contains the lowest
possible risk for a given expected return.
Another main theme in standard finance is known
as the Efficient Market Hypothesis (EMH). The effi-
cient market hypothesis states the premise that all in-
formation has already been reflected in a security’s
price or market value, and that the current price the
stock or bond is trading for today is its fair value. Since
stocks are considered to be at their fair value, propo-
nents argue that active traders or portfolio managers
cannot produce superior returns over time that beat Figure 2.
the market. Therefore, they believe investors should
just own the “entire market” rather attempting to “out-
perform the market.” This premise is supported by What is Behavioral Finance?
the fact that the S&P 500 stock index beats the overall Behavioral finance attempts to explain and increase
market approximately 60% to 80% of the time. Even understanding of the reasoning patterns of investors,
with the preeminence and success of these theories, including the emotional processes involved and the
behavioral finance has begun to emerge as an alter- degree to which they influence the decision-making
native to the theories of standard finance. process. Essentially, behavioral finance attempts to
explain the what, why, and how of finance and invest-
The Foundations of ing, from a human perspective. For instance, behav-
ioral finance studies financial markets as well as
Behavioral Finance providing explanations to many stock market anoma-
Discussions of behavioral finance appear within the lies (such as the January effect), speculative market
literature in various forms and viewpoints. Many bubbles (the recent retail Internet stock craze of 1999),
scholars and authors have given their own interpre- and crashes (crash of 1929 and 1987). There has been
tation and definition of the field. It is our belief that considerable debate over the real definition and va-
the key to defining behavioral finance is to first es- lidity of behavioral finance since the field itself is still
tablish strong definitions for psychology, sociology developing and refining itself. This evolutionary pro-
and finance (please see the diagram located below). cess continues to occur because many scholars have
such a diverse and wide range of academic and pro-
fessional specialties. Lastly, behavioral finance stud-
ies the psychological and sociological factors that
influence the financial decision making process of
individuals, groups, and entities as illustrated below.
The Behavioral Finance Decision Makers
Figure 1.
Figure 1 demonstrates the important interdiscipli-
Figure 3.
nary relationships that integrate behavioral finance.
When studying concepts of behavioral finance, tradi- In reviewing the literature written on behavioral
tional finance is still the centerpiece; however, the be- finance, our search revealed many different interpre-
havioral aspects of psychology and sociology are tations and meanings of the term. The selection pro-
integral catalysts within this field of study. Therefore, cess for discussing the specific viewpoints and
the person studying behavioral finance must have a definitions of behavioral finance is based on the pro-
basic understanding of the concepts of psychology, fessional background of the scholar. The discussion
sociology, and finance (discussed in Figure 2) to be- within this paper was taken from academic scholars
come acquainted with overall concepts of behavioral from the behavioral finance school as well as from
finance. investment professionals.
cognitions (i.e., beliefs, viewpoints). When there is a Panics: Sudden, widespread fear of an economic of
discrepancy between feelings or behaviors (disso- market collapse, which usually leads to falling stock
nance), something must transform to eliminate the prices.
dissonance. Prospect Theory: can be defined as how investors as-
Correlation: a concept from probability (statistics). sess and calculate the chance of a profit or loss in com-
It is a measure of the degree to which two random parison to the perceptible risk of the specific stock or
variables track one another, such as stock prices (stock mutual fund.
market) and interest rates (bond market). Psychology: is the scientific study of behavior and
Crash: a steep and abrupt drop in security market mental processes, along with how these processes are
prices. affected by a human being’s physical, mental state, and
Efficient Frontier: the line on a risk-reward graph rep- external environment.
resenting a set of all efficient portfolios that maxi- Regret Theory: The theory of regret states that indi-
mize expected return at each level of risk. viduals evaluate their expected reactions to a future
Efficient Market Hypothesis (EMH): the theory that event or situation
prices of securities fully reflect all available informa- Sociology: is the systematic study of human social
tion and that all market participants receive and act behavior and groups. This field focuses primarily on
on all relevant information as soon as it becomes avail- the influence of social relationships on people’s atti-
able. tudes and behavior.
Efficient Portfolio: a portfolio that provides the great- Standard Deviation: within finance, this statistic is a
est expected return for a given level of risk. very important variable for assessing the risk of stocks,
Expected return: the return expected on a risky asset bonds, and other types of financial securities.
based on a normal probability distribution for all the Time Value of Money: is the process of calculating
possible rates of return. the value of an asset in the past, present or future. It is
Finance: a discipline concerned with determining based on the notion that the original principal will
value and making decisions. The finance function al- increase in value over time by interest. This means
locates capital, including acquiring, investing, and that a dollar invested today is going to be worth more
managing resources. tomorrow.
Herding or Herd Behavior: herding transpires when
a group of investors make investment decisions on a
specific piece of information while ignoring other
Acknowledgements
pertinent information such as news or financial re- The authors would like to thank the following for their
ports. insightful comments and support: Robert Fulkerth,
January Effect: the January effect is generally thought Steve Hawkey, Robert Olsen, Tom Powers, Hank
to be among the most frequent of the stock market’s Pruden, Hugh Schwartz, Igor Tomic, and Mike
anomalies. Investors each January expect above aver- Troutman. An earlier version of this paper was pre-
age gains for the month, which are most likely caused sented by Victor Ricciardi at the “Annual Colloquium
by the result of a flood of new money (supply) from on Research in Economic Psychology” July 2000 in
retirement contributions, combined with optimism Vienna, Austria. The sponsors of this conference were
for the New Year. the International Association for Research in Eco-
Loss Aversion: The idea that investors assign more nomic Psychology (IAREP) and The Society for the
significance to losses than they assign to gains. Loss Advancement of Behavioral Economics (SABE) in
aversion occurs when investors are less inclined to sell affiliation with the University of Vienna.
stocks at a loss than they are to sell stocks that have
gained in value (even if expected returns are the iden-
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About the Authors
423-428. Victor Ricciardi is currently an adjunct faculty mem-
Juglar, C. (1993). Brief History of Panics in the United States, 3rd ber and doctoral student in finance at Golden Gate
edition. Burlington, Vermont: Fraser Publishing Company
University in San Francisco, California. Victor has
Kahneman, D., Slovic, P. and Tversky, A. (eds.). (1982). Judgment
Under Uncertainty: Heuristics and Biases. Cambridge and New
taught classes in finance, economics and behavioral
York: Cambridge University Press. finance. His dissertation and research work is in the
Kahneman, D. and A. Tversky. (1979). “Prospect Theory: An field of behavioral finance. The topic of his thesis is a
Analysis of Decision Under Risk.” Econometrics, 47:263-291. study of how trustees of private universities make in-
Le Bon, G. (1982). The Crowd: a Study of the Popular Mind. vestment decisions regarding endowment funds, from
Marietta, GA: Cherokee Publishing Company. a behavioral finance perspective.
MacKay, C. (1980). Extraordinary Popular Delusions and the Victor received his MBA in Finance and advanced
Madness of Crowds. New York, NY: Crown Publishing Group. masters in Economics from St. John’s University and
Mahajan, J. (1992). “The Overconfidence Effect in Marketing BBAs in Accounting and Management from Hofstra
Management Predictions.” Journal of Marketing Research, 29,:
329-342. University. Victor began his professional career as a
Morton, H. (1993). The Story of Psychology. New York, NY: Ban-
mutual fund accountant for the Dreyfus Corporation
tam Double Dell Publishing Group, Inc. and Alliance Capital Management. In addition, he has
Olsen, R. A. (1998). “Behavioral Finance and its Implication for been employed as an Economic Analyst at the Fed-
Stock-Price Volatility.” Financial Analysts Journal. March/April: eral Deposit Insurance Corporation (FDIC). He also
10-17. has completed a yet unpublished book with Dr. Igor
Peters, E. (1996). Chaos and Order in the Capital Markets, 2 nd Tomic of St. John’s University on the topic of mutual
Edition. New York, NY: John Wiley & Sons, Inc. fund investing.
Pruden, H. (1998). “Behavioral Finance: What is it?.” Market Helen K. Simon, CFP is President of Personal Busi-
Technicans Association Journal. Available: http://
www.crbindex.com/pubs/trader/btv7n6/btv7n6a3.htm ness Management Services, LLC, located in Fort Lau-
Ricciardi, V. (2000). “An Exploratory Study in Behavioral Finance: derdale, Florida. Helen has resided in South Florida
How Board of Trustees Make Behavioral Investment Decisions since 1974 and has nearly 20 years of professional ex-
Pertaining to Endowment Funds at U.S. Private Universities.” perience in the financial services and investment field.
(Preliminary Dissertation Topic). She serves on the adjunct faculty of Florida State Uni-
Rubin, J. (1989). “Trends—the Dangers of Overconfidence.” Tech- versity and Nova Southeastern University where she
nology Review, 92,: 11-12.
teaches classes in financial management, personal fi-
Schwartz, H. (1998). Rationality Gone Awry? Decision Making
Inconsistent with Economic and Financial Theory. Westport,
nance and financial planning. She received a BBA,
Connecticut: Greenwood Publishing Group, Inc. Magna Cum Laude, from Florida Metropolitan Uni-
Selden, G. C. (1996). Psychology of the stock market, Fifth Print- versity, the CFP designation from The College for Fi-
ing. Burlington, Vermont: Fraser Publishing Company. nancial Planning, an MBA from Nova Southeastern
Shefrin, Hersh (2000). Beyond Greed and Fear. Boston, Massa- University and is currently pursuing a Doctorate of
chusetts: Harvard Business School Press. Business Administration (DBA) with a concentration
Statman, M. (1995). “Behavioral Finance vs. Standard Finance.” in Finance. She also serves on the City of Oakland
Behavioral Finance and Decision Theory in Investment Manage- Park, Florida Employee Pension Board.
ment. Charlottesville, VA: AIMR: 14-22.