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Study of Behavioural Finance
Study of Behavioural Finance
consider all available information in the decision-making process. However, researchers have
uncovered a surprisingly large amount of evidence that this is frequently not the case. Peter L.
Bernstein in Against The Gods states that the evidence "reveals repeated patterns of irrationality,
inconsistency, and incompetence in the ways human beings arrive at decisions and choices when
faced with uncertainty." A field known as "behavioral finance" has evolved that attempts to
better understand and explain how emotions and cognitive errors influence investors and the
decision-making process. Many researchers believe that the study of psychology and other social
sciences can shed considerable light on the efficiency of financial markets as well as explain
many stock market anomalies, market bubbles, and crashes. As an example, some believe that
the out performance of value investing results from investor's irrational overconfidence in
exciting growth companies and from the fact that investors generate pleasure and pride from
owning growth stocks. Many researchers believe that these human flaws are consistent,
predictable, and can be exploited for profit.
[...] The second application of behavioral finance concerns the under pricing of IPOs. Prospect
theory is a descriptive theory of choice under uncertainty. This is in contrast to expected utility
theory, which is normative rather than descriptive. Prospect theory focuses on changes in wealth,
whereas expected utility theory focuses on the level of wealth. Gains and losses are measured
relative to a reference point. Prospect theory also assumes loss aversion. Prospect theory also
incorporates framing—if two related events occur, an individual has a choice of treating them as
separate events (segregation) or as one (integration). [...]
[...] Behavioral finance places an emphasis upon investor behavior leading to various market
anomalies. Behavioral Finance is the study of psychology of investors when faced with financial
decision-making. CONTRIBUTIONS BY VARIOUS PERSONS: Tversky and Kahneman
originally described "Prospect Theory" in 1979. They found that contrary to expected utility
theory, people placed different weights on gains and losses and on different ranges of
probability. They found that individuals are much more distressed by prospective losses than
they are happy by equivalent gains. [...]
[...] Thus Behavioral Finance is the study of emotions in financial decision-making. It is the
study of psychology and economics or the study of anthropology and finance. There are several
aspects of markets, which make investors behave irrationally and cloud their judgment. Human
brain does not work like a compute and instead processes information through shortcuts and
emotional filters to shorten the time required for analysis. The decision arrived through these
filters is not the same which would have been made, if there had been no filters. [...]
[...] It is because of loss aversion that we sell the winners and hold on to the losers. SUNK COST
FALLACY: Sunk Cost Fallacy is another common mistake that people make. It involves
increasing one’s commitment to something based on how much one has already spent.
Averaging cost of purchases explains the behavior anomaly of sunk cost fallacy. To avoid these
mistakes one must know their risk profile and test their loss capacity. Further, one must diversify
one’s portfolio among assets classes like equities, bonds and debt mutual funds and even
diversify their equity portfolio between 12-15 companies. [...]