FINANCE RESEARCH PAPER

TOPIC: IMPACT OF TRADITIONAL FINANCE AND BEHAVIOURAL

FINANCE ON INVESTMENT

COURSE: BBA LLB 1ST YR. [FINANCE]

DATE: 1ST MAY, 2022

SUBMITTED TO:

Prof. SUJAY SEKHAR

SUBMITTED BY:

a) ANJANI PAUL – 81022100333

b) NITYA JHANWAR – 81022100108
c) SAARANSH CHANDEL– 81022100325
 Abstract
This article investigates its readers' investment choices and examines the many aspects of
behavioural finance that are linked to the effect of investments in developing nations like
India. The contrast between conventional finance and behavioural finance is briefly discussed
in the introduction. The rest of the chapter focuses on the numerous characteristics of both
traditional and behavioural finance. The final portion looks at how traditional and
behavioural finance affect investing decisions. The fourth section analyses and contrasts the
findings of several research studies, followed by a summary and conclusion.
Keywords: Behavioural Finance, Traditional Finance, Investment Decision. Efficient Market
HYPOTHESIS: Behavioural finance and traditional finance have impact on decision making
process.
Behavioural finance and traditional finance don’t have any impact on decision making
process.

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 Introduction

Choosing an alternate option from a circumstance with favourable consequences for

individuals or investors requires significant decision-making. The purpose of investing is to
generate profits for investors. Market dynamics and the structure of information impact
investment decisions. As a consequence, investors may obtain negative returns on their
investments for the purpose for which they invested, or they may not achieve satisfactory
results from their investments owing to investor behaviour. According to Buchan, "money is
the manifestation of desire" (2001). According to Kahneman and Tversky (1979) and
Statman (1979), individuals experience discomfort when they realise that the other option
offers superior outcomes (1999). Consequently, behavioural finance is a subfield of
economics that analyses the impact of human emotions and behaviours on stock prices.
The study of how and why the emotions and cognitive biases of investors produce anomalies
in the stock market is the focus of the field of behavioural finance. However, in contemporary
finance, the idea of rationality and theory-based judgments like the Capital Asset Pricing
Model and the efficient market theory presume that individuals are rational and try to
maximise their wealth as much as possible. Nevertheless, in the actual world, individuals act
irrationally in ways that cannot be predicted, and this irrationality is connected to the field of
behavioural finance. The term "behavioural finance" refers to the study of human behaviour
and behaviour in relation to financial markets, whereas "modern finance" defines the actions
of an economic man. The focus of traditional finance is on making decisions on investments
for which all relevant information is presented.
Becker (1962) and Thaler (1990) stated in their research on the role of behavioural economics
and behavioural decision making in the decisions that Americans make regarding their
retirement savings that, contrary to the traditional theory, individuals can share information
and make rational decisions when doing so. These people' features have not altered
throughout time and may be described in depth. According to Phung (2010), behavioural
finance is a relatively new area that combines psychological, cognitive, and behavioural
theory with finance and traditional economics to draw conclusions about people's illogical
decision making. Behavioral finance is a relatively young topic that combines cognitive and
behavioural psychology theory with traditional economics and finance. In 1980, an
interdisciplinary group of researchers from several fields got together for the first time to
develop the behavioural finance theory.

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According to Shefrin (1999), behavioural finance is a significant expansion of the field of
finance that compares the influence of psychology on the behaviour of financial
professionals. Behavioral finance, according to Statman (1999), also examines how emotions
and cognitive errors impact the investor's financial decision-making process. Behavioral
finance examines the emotions of investors with deviant attitudes for two reasons why people
do not learn about their financial views. These two sub-classifications are as follows.
(i) Cognitive Deviations: These deviations are created by time, memory, and
attention, and behavioural finance gives emphasis to these deviations.
(ii) Emotional deviation: is the second type of human behaviour variation that
behavioural finance mostly ignores. The graphic represents investment-related
behavioural finance attitudes. Heuristic simplifications, according to Hirshleifer
and Teoh (2002), are the product of cognitive restrictions that cause emotional
deviations based on deviation evaluations. Ritter (2003) pioneered behavioural
finance by employing models that were less constrained than Von Neumann's. In
this article, it is said that behavioural finance is supported by two pillars, implying
that they are dependent variables. Cognitive psychology comes first, followed by
arbitrage. The study of thought and any systemic errors linked with it is known as
cognitive psychology. The constraints of arbitrage have to do with estimating the
most effective strategy of investing or predicting when arbitrage will be profitable
and when it will not. Behavioural finance has its own theory that assists investors
in making investment decisions and displays market efficiency in terms of share
prices of publicly traded corporations. Behavioural finance is concerned with
people's irrational choices. Ritter (2002) is quoted in an article on behavioural
finance as claiming that behavioural finance is made up of two types of blocks:
arbitrage constraints and cognitive psychology. Investors' behaviour in stocks and
other efficient market investments is studied by cognitive psychology. Individuals'
investment decisions are linked to cognitive biases, demonstrating their effect on
investment decisions and how these behaviourally-related elements affect market
efficiency. The following are some components of cognitive psychology that
impact choices.

• Heuristics
• Overconfidence

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 • Mental accounting
• Framing
• Representativeness
• Conservatism
• Disposition effects
• Loss Aversion
These are all aspects related to an individual's cognitive psychology that influence an
efficient market when investors utilise prescriptions to discover patterns in investing
decisions. Heuristics manifest as the initial dependent variable of cognitive biases when any
change occurs or when they are confronted with a change that is not consistent with their
rules of thumb, resulting in prejudices. Overconfidence, which is also a dependent variable of
cognitive biases, is another related aspect in which people are overconfident in their skills to
conduct work or in their investing decisions. The other aspect is mental decision-making,
which is based on people's thinking abilities concerning decisions that are made
independently by some people but are truly dependent on each other or must be made jointly
in a given decision. Cognitive biases have an impact on the decision-making process, and
their influence on investors' decisions is influenced by two sorts of variables.
i) Heuristics
ii) (ii) Prospect Theory
Diagrammatical Explanation

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 These two variables have a moderate effect on cognitive biases that depend on a subset of
independent variables that are the major source of cognitive illusions in investment
decision-making. Other dependent factors are divided into overconfidence and loss
aversion variables. Kahneman and Tversky (1979) noted in their article Loss Aversion: A
Qualitative Study of Behavioral Finance, "Loss Aversion is the basic concept in
behavioural finance." According to Rabin (1998) and Shalev (1996), people experience
far greater suffering when they lose something than when they gain something. The
graphic below depicts the interconnection and dependence or independence of key
aspects in investment decisions. In their 2005 article titled "Loss Aversion: A Qualitative
Study of Behavioral Finance," Godoi, Marcon, Silva, and colleagues described loss
aversion as a subjective characteristic of financial decision making.

Markowitz's (1952) portfolio selection technique, which is being used in investment

choices today, is the genesis of traditional finance. Its work on capital structure persisted
until Modigliani and Miller finished theirs (1958). The efficient market theory of modern
finance, proposed by Sharp (1964), Mossin (1966), and Fama (1970), symbolises the
evolution of contemporary finance. These Efficient Market Hypotheses provide
information about the stock market's efficiency to efficient computer processing, so
improving its ability to make investment decisions for current and future profits or gains.
The option pricing theory, developed by Black, Scholes, and Merton (1973), is now used
to analyse options. The Modern Finance theory and the Utility Expected theory have a lot
of similarities. The study of efficient markets, or market efficiency, is where
contemporary finance and behavioural finance collide. Market efficiency, according to
Statman (1999), refers to the systematic patronage of trade, wherein stock prices are

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 rational in the sense that they reproduce only significant and useful qualities, such as risk,
and are not affected by psychological elements like sentiments. Byrne and Utkus
questioned why bother with behavioural finance. Investors are not puzzled by information
supplied to them, according to conventional theory, hence a common finance assumption
does not match reality.

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 OBJECTIVE OF THE STUDY
Human psychology has a crucial role in determining which actions to take. It is normal
for humans to commit errors. Understanding cognitive biases, emotional deviance, and
other factors that impact people's decision-making processes is essential. The most crucial
questions to which you must provide answers. What effect may cognitive biases have on
the psychological decision-making processes of investors? Exists a correlation between
behavioural and conventional fiancé that demonstrates their impact on decision-making?
What variables contribute to its determination?

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 CONTRIBUTION OF THE STUDY
The impact of behavioural and conventional finance on investor decision-making is
investigated in this study. This study can help investors make better judgments by
utilising or benefiting from it. This will also help to lower the chances of making a
mistake.

LIMITATIONS OF THE STUDY

Due to the fact that this study does not belong to a particular group or region, the
conclusions cannot be extrapolated to the whole field. It is mostly based on the ideas and
findings of several authors, although individual investors can use particular discoveries
and arguments.

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 IMPACT OF TRADITIONAL FINANCE AND BEHAVIOURAL FINANCE ON
INVESTMENT
Olsen (1998) said in "Investor Irrationality and Self-Defeating Behavior" that people's
behaviour in conventional finance is logical, resulting in profit maximisation. However,
this model is imperfect since it does not completely account for the investing behaviour of
individuals, which is examined in behavioural finance. The Efficient Market Hypothesis
(EMH) is the cornerstone of the Semi-Autonomous System's logic (SAS). All historical
and present data on asset price fluctuations are connected to a robust variant of the
efficient market hypothesis. In classical finance, investment decisions are founded on the
rationality concept, which evaluates the investing behaviour of rational individuals.
However, there is no such thing as flawless rationality in the real world, therefore market
share price fluctuations impact investment decisions. Just as classical finance has an
impact on investment decisions, behavioural finance has an impact on investment
decisions that are impacted by people's prejudices and emotions. Behavioral finance also
influences investing decisions. Baker and Hasem (1974) said that the projected returns,
dividends, and financial stability of a corporation are crucial investing considerations for
individual investors. Baker and Haslem (1977) emphasised, "It is imperative that
investors behave themselves prudently and consider investment risk and return." In recent
decades, the use of mathematical models for evaluating financial data and making
investment decisions has gained in popularity. Investments are based on the existing
financial conditions of a country, such as financial crises that develop on the stock market
as a result of a range of variables that influence investment decisions. The inconsistency
of stock market investors' investing behaviour, such as a change in return rate or
systematic or non-systematic risk, influences their investment selections. The elements
that influence an investor's decision to invest in a developing nation such as India follow
a unique pattern within the same culture and economic group in the United States.
According to Mishra and Dash (2010), the degree of risk is dependent on age, and
individuals display varying levels of risk due to variances across age groups and gender in
risk tolerance during decision making. Individual differences in age and gender can
influence investment behaviour. According to Sultana (2012), the second most significant
factor was "marketability of the stock, prior stock performance, current price volatility,
risk minimization, wealth maximisation, social responsibility, and expert
recommendation." According to Barber and Odean (2008), the majority of traders prefer

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 to purchase companies that have gotten a great deal of market or media attention.
Furthermore, they prefer to invest in equities that have provided them with a better return
in the past.
Individual decision-making, as well as the effects of rational and illogical decisions, were
explored by Ahmed and Khalil (2011). Wickham (2003) asserts that people are
susceptible to decision bias as a result of representative heuristics that cause them to
overvalue low probability activities, resulting in bad trading decisions. Griffin and
Tversky (1992) continue by stating that when individuals make investment decisions,
they reject statistical explanations and give higher weight to source, meaning that they are
predisposed toward strength as opposed to fault. Kliger and Kudryavtsev (2010) focused
on individual decision making by claiming that when heuristics are available, people
often make decisions based on past experience. According to Sevil et al. (2007),
heuristics have a major influence on the stock market decision-making process.

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COMPARISON OF STUDIES RESULT FINDING FACTORS INFLUENCE AND TO
CHECK IMPACT OF BEHAVIORAL FINANCE AND TRADITIONAL FINANCE IN
DEVELOPING COUNTRIES LIKE INDIA
The study of research is based on secondary data from comparative descriptive research
studies to evaluate the notion of whether investors favour rational or irrational decision-
making. Articles used to analyse results in order to characterise behavioural finance and
conventional finance in developing nations such as India, taking into consideration factors
that influence individual investment decisions. Based on the aforementioned research, the
following citations derive inferences on decision-making in India. According to N.Ahmed
et al., small investors on the Bombay Stock Exchange are significantly influenced by
choices. Using basic SPSS 16.0 descriptive analysis of investor behaviour, they
discovered that individual investors' behavioural judgement when investing is impacted
by rationality and whether or not they adhere to rationality. This study discovered that
local investors, such as the Bombay Exchange, do not base their investment decisions on
viewing or considering all available information; rather, they make irrational decisions.
T. Bashir et al. (2013) undertook an investigation of the "factors impacting the decision-
making behaviour of individual investors." This research utilised primary data. The
researchers used a 125-person sample size, 33 items with a six-month effect, and 34
variables to demonstrate that investors display reasonable or illogical behaviour based on
cognitive and emotional aspects. Accounting information, self-image, neutral
information, corporate image, personal financial demands, and advocacy counsel are the
five categories of criteria used to evaluate Cranach alpha for data reliability; their
respective values are 0.620, 0.672, 0.414, 0.588, and 0.620. " High percentages of
individual investors, 77.6%, 71.26%, 71.26%, 70.4%, and 68.8%, consider dividend paid
reputation of the business, feeling for firm's products, become wealthy quick, and firm's
engagement in fixing community problems when selecting stock investments. In contrast,
financial market conditions, stock marketability, majority stockholder opinion, and the
attractiveness of non-stock investments are the least important investment decision
criteria for the vast majority of individual investors (28 percent, 25.6 percent, 23.2
percent, and 16 percent, respectively). Criteria used to evaluate an investor's selection.

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 Ali Rahman utilise primary data analysis in "stock selection behaviour of individual
equity investors in India” to infer investors' investment behaviour by employing
hypothesis; their findings are as follows.
- Downward Spiral Weights: routes, estimates, Standers Error, P value, and their
descriptions are as specified in the original data utilisation research.
All of the study's findings relate to the stock selection behaviour of individual investors in
India. In the supporting description, the effect of the hypothesis and acceptance criteria is
illustrated. According to Singh in Investor Irrationality and Self-Defeating Behavior:
Insights from Behavioral Finance, analysts modify anchoring and overconfidence in
response to new information. These biases may arise in situations where
I. Impact of reaction due to change of prices
II. Implementation of the past practices into future.
III. Lack of focus to necessary underlying stock.
IV. Excessive focus on popular stocks.

Investors should be conscious of their own biases and make every attempt to
eliminate them. Second, investors must be aware of their investment criteria and
the motivations for investing in a certain region. If investors are aware of the area
and goal of their investments, they will be more cognizant of their losses and
make attempts toward sensible investing. Diversification is the third more
lucrative form of investment. Diversification increases the security of a person's
investments.

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 CONCLUSION

It has been discovered that both behavioural finance and classical finance
influence investors' investment decisions. Unquestionably, behavioural factors
have a significant impact on the decisions made by traders. The cognitive
behaviour of investors is essential, suggesting that human behaviour cannot be
ignored while making financial decisions. Prospect theory and heuristics both
contribute to behavioural finance's irrationality. The rational perspective of
investors on classical finance's efficient market theory is essential for generating
bigger profits; yet, in developing nations such as Pakistan, rational decision-
making is unattainable due to uncertainty and a lack of information available to
investors. In the case of searching for sensible investment information, there are a
number of additional problems, including cost and time waste, as well as the
chance of missed opportunities. According to the findings of numerous research,
behavioural finance plays a larger and more crucial role in investors' decision-
making than rational investment decisions, and investors take into account a
greater number of behavioural finance factors when making investment decisions.

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