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Chapter 1

Behavioral Finance

Learning Objectives
Explain Behavioral finance as
Modern Finance
Explain the Nature and Scope of
Behavioral Finance
Describe the Objectives of Behavioral
Finance
Explain the history of Behavioral
Finance

Behavioral Finance: Introduction

Behavioral Finance is a concept developed with the inputs taken


from the field of psychology and finance, which tries to understand
various puzzling observations in stock markets with better
explanations.
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 individuals personality and mindset
Behavioral finance is divide it into two branches.
Micro Behavioral Finance
Macro Behavioral Finance

Behavioral Finance: Introduction

Behavioral Finance as a Science


Behavioral Finance as an Art
Scope
To understand the Reasons of Market Anomalies:
To Identify Investors Personalities
Helps to identify the risks and their hedging
strategies
Provides an explanation to various corporate
activities
To enhance the skill set of investment advisors

Behavioral Finance: Introduction

Objectives
To review the debatable issues in Standard Finance and the
interest of stakeholders.
To examine the relationship between theories of Standard
Finance and Behavioral Finance.
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 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 investors
personalities.
More elaborated discussion on optimum Asset Allocation

Behavioral Finance: History

Behavioral Approach is an approach to understand the


movements in financial markets, which is contrary to
Efficient market Hypothesis (EMH), which has been the key
preposition of traditional finance, which believed that the
financial markets are efficient and highly analytical. Fama
defined efficient markets are those markets in which,
Security prices always fully reflect the available
information.
classical view, Behavioral finance assumes that the irrational
behavior of investor advisors and due to combined and
multiplied effect of investors personalities, markets will not
always be efficient. This inefficiency of financial markets
causes the stock prices to deviate from the predictions of
traditional market models.

Behavioral Finance: Major contributors in Behavioral Finance

Alan Greenspan, the Federal Reserve Chairman for raising


concern for Irrational exuberance with respect to Japan in his
lecture in 1996.
Professor Richard Thaler, from University of Chicago Graduate
Schoolof Business, studied investors behavior responsible for
the creation of Tech Bubble.
Professor Hersh Shefrin from University in Santa Clara,
California contributed in the field by writing the book Beyond
Greed and Fear : Understanding behavioral Finance and the
Psychology of Investing.
Professor Kahneman and Amos Tversky formulated the
Prospect Theory. As a alternative to standard finance, prospect
theory described thet the human judgements are influenced by
Heuristic and disagree with the basic principles of probability

Behavioral Finance: Major Research Work in Behavioral Finance

While dealing with various investment options, the fundamental


question people face in their asset management is that what is the
best strategy for investing in the stock market and to what
extent can the past movements in stock prices be used to
make predictions of the future prices? Is it better to be
focused on fundamentals, whatever they are and whatever
way they have been measured, or to follow the psychology of
the market.
Markowitz theorem and Markowitzs portfolio selection Markowitz
(1952).
The assumption of being risk averse in standard finance is seriously
challenged by Friedman and Savage (1948).
The expected utility theory, developed by Von Neumann and
Morgenstern (1944)
The Expected Utility Theory (EU) was developed by Von Neumann
and Morgenstern in 1944. Hayek (1937)

Behavioral Finance: Major Research Work in Behavioral Finance

Ramsey (1928) was among the first to frame some models for
individuals utility as the concave function of consumption, which giving
rise to numerous of such concave functions.
Tversky and Kahneman (1981) found that, contrary to the expected
utility theory, people assign different weights to gains and losses
Kahneman and Tverksy (1979) derived the observation that the
marginal value of both gains and losses decreases with their magnitude.
Harrison and Kreps (1978) argued that some beliefs force agents to
buy stocks even though they believe stocks are already above their
fundamental value.
Two parameters, centrality and between ness are discussed by Freeman
(1977) regarding the trade of securities.
Ellsberg (1961) first identified the concept of ambiguity aversion, which
occurs when people prefer to bet on lotteries with known probabilities of
winning, rather than those with ambiguous outcome distributions.

Behavioral Finance: Major Research Work in Behavioral Finance

Behavioral finance is defined by Shefrin (1999) as, A


rapidly growing area that deals with the influence of
psychology on the behavior of financial practitioners.
demographical features systematically influence individuals
behavior and their investment decision. Modern financial
economics at times behave with extreme rationality; but,
markets dont. As explained by Barber and Odean
(2001).
Cumulative Prospect Theory coined by Tversky and
Kahneman (1992) provided a good explanation for the
emergence of deposit accounts by simultaneously
integrating the risk-averse and risk-seeking behavior of
investors.
and many more..

Behavioral Finance: The Traditional View to Financial Markets

Weak Form

Semi Strong Form

Historical Information is available

Future prices of stocks can not be

Stock prices adjust all publically

All information is fully reflected in

available information

the stock prices

Few Insiders earn profits, who adjust

Investors respond quickly

Technical Analysis is of little or no

their decision making according to

Insider information is of no value

value

available information

predicted

Strong Form

Fundamental Analysis is of little or


no value

Behavioral Finance: Limitations of Efficient Market Hypothesis

Market imperfections, like delay in information and


Transaction Costs are unexplained.
EMH deals with absolute price changes but not the
relative price changes of the stocks.
Random movement of stock prices does not indicate
the direction of movement.
Other prevalent market anomalies like Low PE
effect, Small firm Effect and The weekend Effect
shows significant deviation from the Efficient Market
hypothesis , hence calls for a need of Behavioral
Finance.

Behavioral Finance: Standard Finance versus Behavioral


Finance
Standard Finance

Behavioral Finance

Standard Finance believes in existence of Rational Markets and Behavioral Finance believe in existence of irrational markets and
Rational investors

irrational Investors

Standard helps in building a rational portfolio

Behavioral finance helps in building an optimal portfolio

Standard Finance theories rest on the assumptions that Explanations of behavioral finance are in light with the real
oversimplify the real market conditions

problems associated with human psychology

Standard Finance explains how investor should behave

Behavioral Finance explains how does investor behave

Standard Finance assumptions believe in idealized financial Behavioral finance assumptions believe in observed financial
behavior

behavior

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