INTRODUCTION TO BEHAVIORAL FINANCE

DENIA H . MARADDAG INSTRUCTOR

BEHAVIORAL FINANCE

• Behavioral finance is an area of study focused on how psychological influences can affect
market outcomes.

• Behavioral finance can be analyzed to understand different outcomes across a variety of

sectors and industries.

• One of the key aspects of behavioral finance studies is the influence of psychological biases.

• Daniel Kahnneman and Amos Tversky – considered as the Fathers of Behavioral Finance

“ Behavioral Finance is afield of finance that proposes psychology-based theories to

explain stock market anomalies such as severe rises or falls in stock price. Within behavioural
finance, it is assumed the information structure and the characteristics of market participants
systematically influence individual’s investment decisions as well as market outcomes”

WHY IS IT IMPORTANT?

• Behavioral Finance seeks to account for this behaviour, and covers the rationality or otherwise
of people making financial investment decisions. Understanding Behavioural Finance helps us to
avoid emotion-driven speculation leading to losses, and thus devise an appropriate wealth
management strategy.

NATURE OF BEHAVIORAL FINANCE

• Behavioral Finance is just not a part of finance. It is something which is much broader and
wider and includes the insights from behavioural economics, psychology and microeconomic
theory. The main theme of the traditional finance is to avoid all the possible effects of
individual’s personality and mindset.

• Behavioral Finance studies the psychology of financial decisionmaking.

• It makes the understanding of investment decision.

• It is the study of investor’s psychology.

BRANCHES OF BEHAVIORAL FINANCE

• MICRO BEHAVIORAL FINANCE:

 - This deals with the behaviour of individual investors. In this, the irrational investors are
compared to rational investors (also known as homo economics or rational economic man)

• MACRO BEHAVIORAL FINANCE:

- This deals with the drawbacks of efficient market hypothesis. EMH is one of the
models in conventional finance that helps us understand the trend of financial markets.

SCOPE OF BEHAVIORAL FINANCE

• To understand the Reasons of Market Anomalies: (like creation of bubbles, the effect of any
event, calendar effect, etc.)

• To identify Investor’s Personalities: Various new financial instruments can be developed to

huge unwanted biases created in financial markets

. • Helps to identify the risks and their hedging strategies.

• Provides an explanation to various corporate activities: Effect of good or bad news, stock split,
dividend decision. Etc.

• To enhance the skill set of investment advisors: Done by better understanding of investor’s
goal, maintaining a systematic approach to advise.

OBJECTIVES OF BEHAVIORAL FINANCE

• To review the debatable issues in Standard Finance.

• To protect the interest of stakeholders in volatile investment scenario.

• To examine the relationship between theories of Standard Finance and Behavioral Finance.

• To analyse the influence of biases on the investment process because of different personalities
in the financial markets.

• To examine the various social responsibilities of the subject.

• To discuss emerging issues in the financial world.

• To discuss the development of new financial instruments to hedge the conventional instruments
against various market anomalies.

• To get the feel of trend of changed events over years, across various economies.

• To examine the contagion effect of various events.

• An effort towards more elaborated identification of investor’s personalities.

 • More elaborated discussion on optimum Asset Allocation according to behavioural aspects as
well as aspects like age, gender, income,etc.,of the investors.

STANDARD (TRADITIONAL) FINANCE

• Standard Finance is the body of knowledge built on the pillars of the arbitrage principles of
Miller and Modigliani, the portfolio principles of Markowitz, capital asset prising model
(CAPM) of William Sharpe, Linter and Black, and option pricing medel of Black and Scholes,
and Merton.

ASSUMPTIONS OF BEHAVIOURAL FINANCE

• LOSS AVERSION : The characteristics of seeking to limit the size of the potential loss rather
than seeking to minimise the variability of the potential returns.

• BOUNDED RATIONALITY: The manner in which human being behave, limits their
rationality.

• DENIAL OF RISK: They may know statistical odds but refuse to believe these odds.

Behavioural Finance is integration of various fields as explained in this figure:

SOCIOLOGY: is the systematic study of human

social behaviour and groups, and influence of
social relationship on attitude and behaviour.

BAHAVIORAL
FINANCE

PSYCHOLOGY: is the scientific study of FINANCE; is the discipline concerned with

behaviour and mental processes, which is determining value and making decisions.
affected by human’s physical, mental, The finance function allocates capital,
and external including the acquisition and allocation.
CHARACTERISTICS OF BEHAVIOURAL FINANCE

1. Heuristics

2. Framing

3. Emotions

4. Market Impact

APPLICATIONS OF BEHAVIORAL FINANCE

1. Investors

2. Corporations

3. Markets

4. Regulators

5. Educations