BEHAVIOUR FINANCE ASSIGNMENT

Q1. What is the difference between traditional and behavioural finance

theories? How did behavioural finance evolve from traditional finance?
Different theories have been developed, and the financial market has been broadly classified
into Traditional Finance and Behavioural Finance theories. Traditional theory is based on the
idea that investors act rationally, with the goal of maximising profit and being risk-
averse. Because of speculations and market inefficiencies, these assumptions that the market
is efficient are violated. As a result, an alternative theory Behavioural Finance, which focuses
on sociological and psychological factors, was developed. The psychological aspect of
investor decision-making This theory emphasises on the market anomalies and inefficiencies
TRADITIONAL FINANCE THEORY
1. Efficient Market Hypothesis (EMH) is the most accepted traditional finance theory.
They believe that market are efficient because of the 3 P’s which are:

 PERFECT INFORMATION

They believe that all the information are available to the public in a very transparent manner
and Investors will take best decision based on the perfect information available.

 PERFECT RATIONALITY

They believe that all the investors are rational and choose the option that gave them the
maximum utility.

 PERFECT SELF INTEREST

2. They also believe that the investors will take the decision for their self-interest.
3. Traditional theory also believes that it is impossible to beat the market. There is perfect
competition and securities are traded at fair value.
4. It may also allow temporary mispricing which according to them will get changed as all
the investors will act rationally.
BEHAVIORAL FINANCE THEORY
It is the study of the influence of the psychological behaviour on investors. It grew as a
branch of psychology that analyses the role of human behaviour in decision making process.
The EMH is generally based on the belief that market participants rationally assess stock
prices based on all current and future intrinsic and external factors.
When it comes to the stock market, behavioural finance believes that it is not fully efficient.
This allows how psychological factors influence stock purchases and sales. Behavioural
finance theories have been used to provide clearer explanations for significant market
anomalies such as bubbles and deep recessions.
Difference between the traits of both the finance theories:
 TRADITIONAL FINANCE THEORY BEHAVIOURAL FINANCE THEORY
Investors are “Rational” Investors are “Normal” not “Rational”
Investors do not change their pattern of Investors change their decision or pattern
investing. according to the situation.

They do not get confused by cognitive Investors can make cognitive errors that
approach (information passing errors). may led to wrong decisions.

It believes that market is efficient.
Investors have full self-control.
It follows all the rules and expectations
which are followed universally that is
why it is said to be normative.
It holds that market are not fully
efficient.
Investors have limited self-control.
In this decision are based on emotional
biases and effected by personal feeling or
opinion that is why it is said to be
subjective.

Behaviour Finance is the study of the influence of the psychological behaviour on investors.
It grew as a branch of psychology that analyses the role of human behaviour in decision
making process. Behavioural finance can be thought of as the combination of traditional
finance and psychology, it aims to explain stock market anomalies and how human behaviour
and psychology can create inefficiencies and mispricing within the market.
Behaviour finance have evolved from traditional finance over the years since it was first
introduced as a concept in the early 1980s. Investors were often thought of as being
economically 'irrational', frequently falling victim to cognitive biases in their pursuit of what
traditional finance calls 'rational' wants. Identifying people as having 'normal' wants and how
these, rather than cognitive errors and shortcuts, tend to underlie and influence many aspects
of financial behaviour.
Finance theorists first began to consider the idea that the laws of investing were not quite as
clean as they had originally theorized. And, as computers have become more powerful it has
become possible to analyze the mountains of data to prove these thoughts true. From the
collective messiness in breakdowns of traditional finance theory a new field within finance
has sprung up. This new field has been named behavioural finance.
After the creation of several theories, behavioural psychologists and finance theorists began
to join forces to research anomalies in financial markets and the result of this research was
the creation of the field of behavioural finance. Today, behavioural finance researchers are
questioning even the most basic of finance laws to find out how investor biases and the limits
of arbitrage affect the efficiency of capital markets.
Q2. With the help of real-life example elaborate the importance of
behaviour and emotions in creating asset pricing bubbles?
Behaviour and emotions plays an important role in creating asset pricing bubble. In case of
tulipmania we have seen different behaviour and emotions that led to the bursting of this
bubble.
Tulipmania is the first recorded incident in stock market crash happened in Netherlands (then
Holland) and plague led to the outbreak of this crash. It took place in the 17th century when
Dutch investors purchased tulips, pushing their prices to unprecedented highs. During
Tulipmania, the average price of a single flower exceeded the annual income of a skilled
worker and cost more than some houses at the time. Tulipmania reflects the general cycle of a
bubble, from the irrational biases and group mentalities that push prices of an asset to an
unsustainable level, to the eventual collapse of those inflated prices.
Some of the behaviour and emotions that I have noticed which led to this bubble are:
 Investors lose track of rational expectations.
We let our preference for a good story cloud the facts and our ability to make rational
decisions. This means that we may be drawn towards a less desirable outcome simply
because it has a better story.

 Herding mentality of the investors

Herd mentality bias refers to investors’ tendency to follow and copy what other
investors are doing. They are largely influenced by emotion and instinct, rather than
by their own independent analysis. This guide provides examples of how investors
may succumb to herd bias, as part of behavioural finance theory.

 Psychological biases lead to a massive upswing in the price of the tulip.

Some historians believe that the popular accounts of tulipmania were exaggerated by
later retellings and that the actual extent of tulip speculation was much more limited
than originally believed.

 A positive-feedback cycle continues to inflate prices.

When stock trader join to buy tulips and always give positive feedback which made a
positive mentality in the mind of the normal people to invest their savings in this.
People starting believing on the feedbacks which led to huge price rise.

 Investors realize that they are holding an irrationally priced asset.

Some historians believe that the popular accounts of tulipmania were exaggerated by
later retellings and that the actual extent of tulip speculation was much more limited
than originally believed.
 Prices collapse due to a massive sell-off, and an overwhelming majority go bankrupt.
Eventually, prices peaked, and then drastically collapsed over the course of a week,
causing many tulip hoarders to lose their fortunes.