Behavioral Finance
Unit 1
Syllabus:
• Behavioural Finance: Nature, Scope, Objectives and Significance & Application.
History of Behavioural
• Finance, Psychology: Concept, Nature, Importance, The psychology of financial
markets, The psychology of
• investor behaviour, Behavioural Finance Market Strategies, Prospect Theory, Loss
aversion theory under
• Prospect Theory & mental accounting—investors Disposition effect
Course Objective
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To understand the basic meaning of the subject behavioural finance
To understand the investors’ psychology
Market strategies
Theories of behavioural finance
Behavioral Finance: Meaning
• Behavioural finance is the study of the influence of psychology on the
behavior of financial practitioners and the subsequent effect on markets.
• Behavioural finance is of interest because it helps explain why and how
markets might be inefficient.
Nature of Behavioral Finance
• Most people know that emotions affect investment decisions. People in the
industry commonly talk about the role greed and fear play in driving stock
markets. Behavioural finance extends this analysis to the role of biases in
decision making, such as the use of simple rules of thumb for making
complex investment decisions.
• Behavioural finance takes the insights of psychological research and
applies them to financial decision
Nature of Behavioral Finance
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Behavioural finance studies the psychology of financial
decision-making.
• It makes the understanding of investment decision.
• It is the study of investor’s psychology.
• It is analytical in nature.
Scope
• Identify Investor’s Personality
• Helps to identify risk
• Provides explanations to various corporate
activities
• Enhance the skill set to investment advisors
• To understand the market anamalities
Objective of Behavioural Finance
• To study emerging issues in financial
market
• To understand the psychology of the
investors’
• To study the change in trends in investment
Objective of Behavioural Finance
• To study the investment decision
• Develop the strategy of financial decision
• Study the scope of investment decision
Psychology
• Psychology is concerned with all aspects of
behaviour and with the thought, feelings,
and motivation underlying that behaviour
• Psychology is defined as the scientific study
of human behaviour with the object of
understanding why living being behave as
they do.
Scope of Psychology
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Social Psychology
Behavioural Psychology
Applied Psychology
Educational Psychology
Nature of psychology
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Psychology as science
Psychology as social science
Psychology as positive science
Psychology as applied science
Psychology of financial market
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Market psychology
Boom and cycles
Psychology of investors
Psychology of the rational man
Psychology of investors’
behaviour
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Behavioural approach
Cognitive approach
Psychoanalytic approach
Humanistic approach
Eclectic approach
Behavioural finance: Market
strategy
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Market timing
Buy and hold strategy
Technical analysis as tool
Behavioural indicators
Psychology of financial market:
• Modern investment theory says that, at all times, market prices
equal fundamental value and that asset returns in the crosssection reflect relative exposures to systematic non-diversifiable
risk. Despite decades of data analysis, empirical support for this
theory remains thin.
Prospect Theory
The theory states that people make decisions based on the potential value of
losses and gains rather than the final outcome, and that people evaluate
these losses and gains using certain heuristics.
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The foundation of prospect theory is that investors are much more
distressed by prospective losses than they are happy about prospective
gains.
Loss aversion theory
• In economics and decision theory, loss aversion refers to people's
tendency to strongly prefer avoiding losses to acquiring gains.
• Most studies suggest that
psychologically, as gains.
losses
are
twice
as
powerful,
• This leads to risk aversion when people evaluate an outcome
comprising similar gains and losses; since people prefer avoiding
losses to making gains.
Mental Accounting
• Mental accounting theory, framing means that the way a
person subjectively frames a transaction in their mind will
determine the utility they receive or expect.
• It is a tendency of the brain to create short cuts with how it
perceived the information and ending up with outcomes
that is difficult to be viewed in any other way. The results
of these mental accounting are that it influence decisions in
unexpected ways
Investors’ Disposition Effect
• The disposition effect is an anomaly discovered
in behavioral finance. It relates to the tendency of investors
to sell shares whose price has increased, while keeping
assets that have dropped in value.
Investors’ Disposition Effect
• Investors are less willing to recognize losses (which they
would be forced to do if they sold assets which had fallen
in value), but are more willing to recognize gains. This is
irrational behavior, as the future performance of equity is
unrelated to its purchase price.