Introduction to behavioral finance

1. Nature, Scope, Objectives and
Significance of Behavioural Finance

2. Behavioral Finance: Introduction
Behavioral Finance:
• It is a concept developed with the inputs taken from
the field of psychology and finance.
• It tries to understand various puzzling observations in
stock markets with better explanations.
• The behaviour of individuals, practitioners, markets
and managers is sometimes characterized as
irrational.

3. Behavioural Finance: Introduction
Behavioural Finance:
• Behavioural Finance denotes the study of finance based
on credible assumptions about how people behave, often
confirmed by psychological experiments.
• Shefrin (2005) in his book on behavioural asset pricing
states ‘Behavioural finance is the study of how psychology
phenomena impact financial behaviour’.

4. Behavioral Finance
People in standard finance are rational. People in
behavioral finance are normal.
Meir Statman

5. Behavioral Finance: Introduction
Behavioral Finance:
• Some decisions are simple choices like, which brand
of toothpaste we will use, how hard we will study in
behavioural finance.
• Other decisions such as whether we should buy a
particular stock, how should we invest in tax saving
instruments, etc impact our financial well being.

6. Why Behavioral Finance??????
• Conventional" or "modern" finance is based on rational and logical theories,
such as the capital asset pricing model (CAPM) and the efficient market
hypothesis (EMH).
• These theories assume that people, for the most part, behave rationally and
predictably.
• One of the most rudimentary assumptions that conventional economics and
finance makes is that people are rational "wealth maximizers" who seek to
increase their own well-being.
• Behavioral finance seeks to explain our actions, whereas modern finance
seeks to explain the actions of the "economic man"

7. Behavioural Finance: Introduction
Nature
• Behavioral Finance is just not a part of finance.
• It is something which is much broader and wider and
includes the insights from behavioral 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

8. Behavioural Finance: Introduction
Behavioural finance is divide it into two branches.
• 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 economicus 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.

9. Behavioral Finance: Introduction
• Behavioral Finance as a Science:
• Science is a systematic and scientific way of observing,
recording, analyzing and interpreting any event.
• Behavioural Finance has got its inputs from traditional
finance which is a systematic and well designed subject
based on various theories.
• On this basis behavioural finance can be said to be a
science .

10. Behavioral Finance: Introduction
• Behavioral Finance as an Art
• In art we create our own rules and not work on rules of
thumb as in science.
• Art helps us to use theoretical concepts in the practical
world.
• Behavioural finance focuses on the reasons that limit the
theories of standard finance and also the reasons for
market anomalies created.
• It provides various tailor made solutions to the investors
to be applied in their financial planning.
• Based on above behavioural finance can be said to be
an art of finance in a more practical manner.

11. Behavior
• Trend is holding – Lets Buy
• Good thing I didn’t wait
• I will use this correction to
increase my position
Greed
• Don’t want to sell at a loss,
lets wait for it to recover
• Enough, I am selling it
• Good thing I sold everything
• I should not have sold
Fear

12. Behavioral Finance: Objectives
• Correct Decision making
• Provideknowledgetounawareinvestor
• Examiningtheinvestorsbehaviour
• IdentifiesEmotionsandMentalErrors
• Maintainingconsistentapproach
• DeliveringwhattheClientExpects.
• EnsuringMutualBenefits.

13. Behavioral Finance: Introduction
Objectives
• 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 behavioral aspects as well as aspects like
age, gender, income etc of the investor.

14. Comparison
Behavioural Finance
1) Recognises how investors
make decision.
2) Based on Micro & Macro
behavioural Finance
3) It recognise that People
employ imperfect rules of
thumb
4) Assumes that perception of
risk and return are
significantly influenced by
how decision problem
framed.
Traditional Finance
1) How investors should
behave
2) Based on neoclassical
Economics
3) Assumes that people
process data appropriately
and correctly
4) It presupposes that people
view all decision through
the transparent and
objective lens of risk and
return

15. Comparison
Behavioural Finance
5) Prices are pushes by
investor to unsustainable
levels in both directions
6) Observes that individual
sometimes can have both
risk averse and risk seeking
behaviour.
Traditional Finance
5. EMH views that price
follow random walk.
6. Utility theory of
diminishing marginal
returns

16. Behavioral Finance: Scope
• 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 hedge 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.

17. 1. Inflation and Stock Market
2. Understanding of Initial Public Offerings (IPO)
3. Investors
4. Corporations
5. Markets
6. Regulations
7. Education
Behavioral Finance: Scope

18. Features of Behavioral Finance
1. Heuristic
2. Framing
3. Emotions
4. Market Impact

19. Significance of Behavioral Finance
1. Determining Goals of Investor
2. Signifies that Investor are Emotional
3. Defines Investor’s Biases
4. Helpful for Financial Advisor and Fund Manager
5. Helps in Investment Decision.

20. Limitations of Behavioral Finance
1. Lacking in discipline
2. Analogy
3. Beyond the narrow micro level study
4. Not pervasive in nature