Instructor

Dr. Nabeel Safdar

Introduction
 The Central assumption of the traditional finance model is that
people are rational.
 Standard Finance theories are based on the premises that
investor behaves rationally and stock and bond markets are
efficient.
 Behavior finance was considered first by the psychologist Daniel
Kahneman and economist Vernon Smith, who were awarded the
Nobel Prize in Economics in 2002.
 Behavior finance is an attempt to explain how the psychological
dimensions influence investment decisions of individual
investor, how perception influences the mutual funds market as
a whole.
 It is worth exploring whether field of psychology helps investor
to make more reasonable investment decisions
Rational Behavior
 A rational behavior decision-making process is based
on making choices that result in the most optimal
level of benefit or utility for the individual. Most
conventional economic theories are created and used
under the assumption all individuals taking part in an
action/activity are behaving rationally.
Behavioral Finance
 According to conventional financial theory, the world
and its participants are, for the most part, rational
"wealth maximizers". However, there are many
instances where emotion and psychology influence
our decisions, causing us to behave in unpredictable or
irrational ways
Behavioral Finance
 Viewed as a field, behavioral finance is the application
of psychology to financial decision making and
financial markets.
 Viewed as a process, behavioral finance is about the
transformation of the financial paradigm from a
neoclassical based framework to a psychologically
based framework.
Behavioral finance
 Relatively a new field which seeks to provide explanation for
people’s economic decisions.
 It is a combination of behavioral and cognitive psychological
theory with conventional economics and finance.
 Inability to maximize the expected utility (EU) of rational
investors leads to growth of behavioral finance research within
the efficient market framework.
 Behavioral finance research is an attempt to resolve
inconsistency of Traditional Expected Utility Maximization of
rational investors within efficient markets through explanation
based on human behavior.
 For instance, Behavioral finance explains why and how markets
might be inefficient.
Neoclassical Finance vs. Behavioral
Finance
 Neoclassical finance has both strengths and weaknesses.
 Among its main strengths is its systematic, rigorous
framework.
 Among its main weaknesses is its reliance on the unrealistic
assumption that all decision makers are fully rational.
 Behavioral finance also has both strengths and weaknesses.
 Among its main strengths is its use of assumptions based on
findings from the psychology literature about how people
deviate from fully rational behavior.
 Among its main weaknesses is the reliance by its proponents
on an ad hoc collection of models that lack mutual
consistency and a unifying structure.
 Are equity valuation errors are systematic and therefore
predictable?
 Efficient markets view: prices follow a random walk, though
prices fluctuate to extremes, they are brought back (regression
to the mean) to equilibrium in time.
 Behavioral finance view: prices are pushed by investors to
unsustainable levels in both directions. Investor optimists are
disappointed and pessimists are surprised. Stock prices are
future estimates, a forecast of what investors expect tomorrow’s
price to be, rather than an estimate of the present value of
future payments streams.
Traditional Finance VS Behavioral
Finance
 Traditional finance assumes that people process data appropriately and
correctly. In contrast, behavioral finance recognizes that people employ
imperfect rules of thumb (heuristics) to process data which induces
biases in their belief and predisposes them to commit errors.
 Traditional Finance presupposes that people view all decision through
the transparent and objective lens of risk and return. Put differently,
the form (or frame) used to describe a problem is inconsequential. In
contrast, behavioral finance postulates that perceptions of risk and
return are significantly influenced by how decision problem is framed.
In other words, behavioral finance assumes frame dependence.
 Traditional finance assumes that people are guided by reasons and
logic and independent judgment. While, behavioral finance,
recognizes that emotions and herd instincts play an important role in
influencing decisions.
Traditional Finance VS Behavioral
Finance
 Traditional finance argues that markets are efficient, implying
that the price of each security is an unbiased estimate of its
intrinsic value. In contrast, behavioral finance contends that
heuristic-driven biases and errors, frame dependence, and effects
emotions and social influence often lead to discrepancy between
market price and fundamental value.
 EMH views that price follow random walk, though prices
fluctuate to extremes, they are brought back to equilibrium in
time. While behavioral finance views that prices are pushed by
investors to unsustainable levels in both direction. Investor
optimists are disappointed and pessimists are surprised. Stock
prices are future estimates, a forecast of what investors expect
tomorrow ’s price to be, rather than an estimate of the present
value of future payment streams.
Characteristics of Behavioral Finance
 Four Key Themes- Heuristics, Framing, Emotions and
Market Impact characterized the Field.
 These themes are integrated into review and
application of investments, corporations, markets,
regulations, and educations-research.
 Heuristics
 Framing
 Emotions
 Market Impact