BEHAVIOURIAL FINANCE

PRESENTED BYSIMRAN KAURMBA 2ND YEAR

INTRODUCTION TO BEHAVORIAL FINANCE

A theory of finance that attempts to explain the decisions of investor by viewing them as rational actors looking out for their self-interest, given the sometimes inefficient nature of the market. 

Combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. 

Combines social and psychological theory with financial theory as a means of understanding how price movements in the securities markets occur independent of any corporate actions.

NATURE OF BEHAVORIAL FINANCE

Bridge gap between finance and psychology Two types: 1. Rational finance paradigm2. Irrational finance paradigm Rational finance paradigm: investors act rationally and consider

all available information in decision-making process Irrational finance paradigm: behavior of an individual is

determined by own mind Stimulating field of scholarship

SCOPE OF BEHAVORIAL FINANCE

Inflation and stock market Underpricing of Initial Public Offering Investors Corporations Markets Regulations Education

OBJECTIVES OF BEHAVORIAL FINANCE

Correct decision making Provide knowledge to unaware investors Identifies emotions and mental errors Delivering what the client expects Ensuring mutual benefits Maintaining a consistent approach Examining a consistent approach

SIGNIFICANCE OF BEHAVORIAL FINANCE

Determining goals of investors Defines investors’ biases Manages behavioural biases Helps in investment decisions Helps for financial advisors’ and fund managers Signifies that investors are emotional

MARKET STRATEGIES

Market timing Technical analysis Financial fraud Pyramid scheme Efficient market hypothesis

PROSPECT THEORY

Developed by Kahneman and Tversky in 1979 Shows how people manage risk and uncertainty Most central element of prospect theory is S-shaped value

function Value

GainLoss

LOSS AVERSION THEORY

People weigh all potential gains and losses in relation to some benchmark reference point

Depicts tendency of people to show greater sensitivity to losses than gains

Types1. Loss on the basis of “valence” or desirability2. Loss on the basis of changes in possession

MENTAL ACCOUNTING

People’s tendency to code, categorise and evaluate economic outcomes

Primary reason is to enhance our understanding of the psychology of choice

3 components1. Perception of outcomes and the making and evaluation of

decisions2. Assignment of activities to specific accounts3. Determination of time periods to which different mental

accounts relates

INVESTORS DISPOSITION EFFECT

Disposition effect: notion of framing to the realization of losses Refer to asymmetric risk aversion, according to which investors

are risk-averse when faced with gains and risk-seeking when faced with losses

CONCEPT OF PSYCHOLOGY

Behaviour Personality Motivation intelligence

NATURE OF PSYCHOLOGY

Study of experience Study of mental processes Study of behaviour

IMPORTANCE OF PSYCHOLOGY

Helps to identify goals Helps to understand the investors attitude Helpful in decision making Helps to identify the financial market environment

PSYCHOLOGY OF FINANCIAL MARKETS

Offers an understanding of financial market process which goes beyond cognitive aspects alone

Provides insights into the connection between the subjective experience of market participants and objective market processes

Offers insight into the difference between market participants

PSYCHOLOGY OF INVESTOR BEHAVIOR

Incorporates both quantitative and qualitative aspect Examines the mental processes and emotional issues Different biases1. Familiarity bias2. Self-attribution bias3. Trend-chasing bias4. Behavorial bias

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