INTRODUCTION TO BEHAVIORAL FINANCE

LEARNING OBJECTIVES:
□ Understand why there is a need for behavioral □ Explain why people make irrational financial
finance. decisions.
□ Differentiate traditional and behavioral finance. □ Discuss the key concepts of behavioral finance.

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 behavior of individuals, practitioners, markets and managers is sometimes characterized as irrational.
➢ It focuses on the fact that investors are not always rational, have limits to their self-control and are influenced
by their own biases.
➢ Behavioral 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 behavioral asset pricing states “Behavioral finance is the study of how psychology
phenomena impact financial behavior”.
➢ People in traditional finance are rational. People in behavioral finance are normal. - Meir Stratman

RATIONAL - Investors make decisions based on all available information.

NORMAL - recognizes that investors are humans and make decisions influenced by their emotions, biases, and
cognitive limitations.
BIASES - are brain tricks that can make one think wrong.
MOOD - No matter how logical the choice seems, our feelings play a big role in making it.

WHAT IS BEHAVIORAL FINANCE?

• Behavioral Finance is the study of the influence of psychology on the behavior of investors or financial analysts.
• Behavioral Finance a subfield of behavioral economics, proposes that psychological influences and biases affect
the financial behaviors of investors and financial practitioners.
• Behavioral Finance is the study of the effects of psychology on investors while taking financial decisions.
• Behavioral Finance is the study of investor’s psychology when making financial decisions.

NATURE OF BEHAVIORAL FINANCE

• Behavioral finance is just not 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.

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 BRANCHES OF BEHAVIORAL FINANCE

1. BEHAVIORAL FINANCE MICRO

➢ Refers to the study of how individuals make financial decisions at the individual level.
➢ It focuses on the psychological and emotional factors that influence financial behavior, such as heuristics,
biases, and decision making biases.
➢ Helps to understand the behavior of individual investors and to develop strategies to help them make better
financial decisions.

2. BEHAVIORAL FINANCE MACRO

➢ Refers to the study of how collective financial decisions made by groups, organizations, and markets are
influenced by psychological and emotional factors.
➢ It seeks to understand how financial market outcomes, such as asset prices and returns, are impacted by the
behavior of investors and other key participants.
➢ Helps to understand how financial markets and the economy are influenced by psychological and emotional
factors and how these factors can lead to market inefficiencies and systematic risks.

SCOPE OF BEHAVIORAL FINANCE

A. To understand the reasons for market anomalies.
Behavioral finance offers explanations and solutions to a variety of market irregularities.
B. To identify Investor’s Personalities.
An in-depth look at behavioral finance can aid in recognizing the many types of investor personalities.
C. Helps to identify the risks and their hedging strategies.
Because of various anomalies in the stock markets, investments these days are not only exposed to the
identified risks but also the uncertainty of the returns.
D. Provides an explanation to various corporate activities.
Effect of good or bad news, stock split, dividend decisions etc.
E. To enhance the skill set of investment advisors.
This can be done by providing a better understanding of the investor’s goals, maintaining a systematic approach
to advice, earning the expected return, and maintaining a win-win situation for both the client and the advisor.

ADVANTAGES OF STUDYING BEHAVIORAL FINANCE INCLUDE:

1. Improved understanding of financial decision-making: Behavioral finance provides a more nuanced
understanding of financial decision making by taking into account the role of psychological and emotional
factors.
2. Better investment strategies: By understanding the psychological and emotional biases that can impact
investment decisions, behavioral finance can help develop investment strategies that are more robust and
effective.
3. Improved financial education and advice: By providing a better understanding of how people make financial
decisions, behavioral finance can help to improve financial education and advice and make it more relevant and
effective.
4. Better public policy and regulation: By providing insights into the psychological and emotional factors that
influence financial decision making, behavioral finance can inform public policy and regulation, making it more
effective and better targeted.

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 DISADVANTAGES:

1. Limited empirical evidence: While there is a growing body of evidence in behavioral finance, some of the
theories and models have not been fully tested and remain subject to debate and revision.
2. Complexity: Behavioral finance can be a complex field, and some of the theories and models can be difficult to
understand and apply.
3. Potential for overreliance on psychological factors: While psychological and emotional factors do play a role in
financial decision making, it is important to recognize that there are many other factors that can impact financial
decisions, including economic, political, and cultural factors.

DIFFERENCE BETWEEN TRADITIONAL AND BEHAVIORAL FINANCE

TRADITIONAL FINANCE BEHAVIORAL FINANCE

Assumes that investors are rational and Recognizes that investors are humans and make decisions
make decisions based on all available influenced by their emotions, biases, and cognitive limitations.
information.
Assumes that the financial markets are Believes that the finacial markets are not always efficient and
efficient and that prices reflect all available that there are opportunities for investors to profit from market
information. anomalies.
Is normative, meaning that it provides Is decriptive, meaning that it describes how investors make
guidelines on how investors should make decisions.
decisions.
Its focus is on mathematical models and Its focus on psychology and behavioral economics.
statistical analysis
Older field of study Newer field of study

BEHAVIORAL FINANCE AS A SCIENCE AS WELL AS AN ARt

Behavioral Finance as a Science:
➢ Science is a systematic and scientific way of observing, recording, analyzing and interpreting
any event.
➢ Behavioral finance has got its inputs from traditional finance which is a systematic and well
designed subject based on various theories.
➢ On this basis behavioral finance can be said to be a science.
➢ 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.
➢ Behavioral 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 behavioral finance can be said to be an art of finance in a more practical
manner.
IMPORTANCE OF BEHAVIORAL FINANCE
➢ Behavioral finance helps us understand how financial decisions around things like
investments, payments, risk, and personal debt, are greatly influenced by human emotion,
biases, and cognitive limitations of the mind in processing and responding to information.
➢ The goal of behavioral finance is to aid in the understanding of why individuals make various
financial decisions and how those decisions influence the market. It is also useful in the
analysis of fluctuations and the levels of market prices to be used for predictions and for
purposes of making decisions.

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 CHARACTERISTICS OF BEHAVIORAL FINANCE
1. HEURISTICS:
➢ are referred as rule of thumb, which applies in decision making to reduce the cognitive resources to solve a
problem.
➢ These are mental shortcuts that simplify the complex methods to make a judgment. Investor as decision
maker confronts a set of choices within certainty and limited ability to quantify results.

2. FRAMING
➢ The decision-makers perception about a problem and its possible outcomes is what is referred to as the
decision frame.
➢ It is affected by the presentation, person’s characteristics, and perception about the question despite the fact
remaining the same.
➢ Psychologists refer this behavior as a “frame dependence” behavior.

3. EMOTIONS
➢ Most human decisions are driven by human needs, desires, fear, fantasies, etc.
➢ The term “animal spirit” given by John Keynes’s indicates the inner urge of market participants to engage in
more investment and consumption.
➢ Emotions have a very important role in explaining investor choices, which thereby shape the financial
markets.
➢ Most of the times emotions are the main reason for people not making a rational choice.

.4. IMPACT ON MARKETS

➢ Behavioral finance believes that market prices do not appear to be fair.
➢ Standard finance argues that investors’ mistakes would not affect market prices because when prices
deviate from fundamental value, rational investor would exploit the mispricing for their own profit.

BEHAVIORAL FINANCE CONCEPTS

Behavioral finance typically encompasses five main concepts:

1. Mental accounting
➢ It refers to the propensity for people to allocate money for specific purposes.
➢ Refers to the tendency for people to seperate their money into seperate accounts based on a variety of
subjective criteria, like the source of the money and intent for each account.
➢ According to the theory, individuals assign different functions to each asset group, which has an often irrational
and detrimental effect on their consumption decisions and other behaviors.
➢ For instance, people may feel that money saved for a new house or their children’s college fund is too
“important” to relinquish. As a result, this “important” account may not be touched at all, even if doing so would
provide added financial benefit.

2. FRAMING
➢ The decision-makers perception about a problem and its possible outcomes is what is referred to as the
decision frame.
➢ It is affected by the presentation, person’s characteristics, and perception about the question despite the fact
remaining the same.
➢ Psychologists refer this behavior as a “frame dependence” behavior.

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 3. Emotional gap
➢ The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety,
anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices.

4. Anchoring
➢ Anchoring refers to attaching a spending level to a certain reference. Examples may include spending
consistently based on a budget level or rationalizing spending based on different satisfaction utilities.
➢ The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point- even
though it may have no logical relevance to the decision at hand. Although it may seem an unlikely phenomenon,
anchoring is fairly prevalent in situations where people are dealing with concepts that are new and novel.

5. Self-attribution or Overconfidence
➢ Self-attribution refers to a tendency to make choices based on overconfidence in one's own knowledge or skill.
Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend
to rank their knowledge higher than others, even when it objectively falls short.
➢ Overconfidence (i.e. overestimating or exaggerating one’s ability to successfully perform a particular task) is not
a trait that applies only to fund managers. Consider the number of times that you’ve participated in a competition
or contest with the attitude that you have what it takes to win - regardless of the number of competitors or the
fact that there can only be one winner.
➢ Keep in mind that there’s a fine line between confidence and overconfidence. Confidece, implies realistically
trusting in one’s abilities, while overconfidence usually implies an overly optimistic assessment of one’s
knowledge or control over a situation.

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