Module 1 - Introduction To Behavioral Finance

PBSBAFM006 – BEHAVIORAL FINANCE
MODULE 1 - Introduction to Behavioral Finance
Introduction
Human behavior is part of one’s personality and very difficult to change. As an investor, one may
even realize that one’s behavior is affecting returns, but it can be hard to appreciate just how much of
an impact behavioral characteristics can have on whether one’s financial goals are reached.
At its core, behavioral finance attempts to understand and explain actual investor and market
behaviors versus theories of investor behavior. This idea differs from traditional (or standard) finance,
which is based on assumptions of how investors and markets should behave.
As Meir Statman's quote puts it, standard finance people are modeled as “rational,” whereas
behavioral finance people are modeled as “normal.” This can be interpreted to mean that “normal”
people may behave irrationally—but the reality is that almost no one behaves perfectly rationally. We
will delve into the topic of the irrational behaviors of markets at times; however, the focus of the module
is on individual investor behavior. In this module, we define behavioral finance and break down its
components for better understanding.
Intended Learning Outcomes
At the end of this module, you can have a better understanding of the basics of as well as the
effects of behavioral biases on the investment process. By doing so, would-be investors and their
advisors may be able to improve economic outcomes and attain stated financial objectives.
Topic Outline
1. Introduction to Behavioral Finance

2. Traditional Finance vs. Behavioral Finance
3. History of Behavioral Finance
4. Awareness of Biases
5. Overcoming Behavioral Finance Issues
The module is for the exclusive use of the University of La Salette, Inc. Any form of reproduction, distribution, uploading, or
posting online in any form or by any means without the written permission of the University is strictly prohibited. vii
Contents
INTRODUCTION TO BEHAVIORLA FINANCE
What is behavioral finance how does it affect your financial decisions?
Behaviour is all about emotions, personalities, psychology, and sociology. And finance is all
about money, investments, numbers, equations, statistics, and balance sheets.
The most common assumption of standard finance is that human beings are "rational."
This means that humans analyze the pros and cons of any situation and then choose the
one which is best for them.
But the critical question is, are we rational? And if we are rational, then why do we throw lavish
birthday parties or luxury wedding receptions because these decisions are certainly not rational.
In reality however, according to Ahiller (199), investors do not think and behave rationally. In
the contrary, investors are driven by greed and fear under uncertainty.
In other wirds, investors are misinformed by extremes of emotion, subjective thinking, and the
whims of the crowd.
In simple terms, Behavioral Finance is: Psychology + Finance
Psychology is the study of mind and behavior. It encompasses the biological

influences, social pressures, and environmental factors that affect how people think act,
and feel.
Finance is defined as the management of money and includes activities such as

investing, borrowing, lending, budgeting, saving, and forecasting. There are three main
types of finance: (1) personal, (2) corporate/business, and (3) public/government.
The behavioral economic theory states that:
➢ Markets are inefficient.

➢ Humans are irrational.
Building blocks of Behvioral Finance:
• Cognitive psychology refers to how people think. People make systematic errors in the
way that they think. They seem to be overconfident and basically put too much weight
on recent experience.
• Limits to arbitrage refers to predicting in what circumstances arbitrage forces will

be effective, and when they won’t be.
Definitions of Behavioral Finance
➢ Behavioral finance is the study of the effects of psychology on investors and

financial markets. It focuses on explaining why investors often appear to lack self-
control, act in their own best interest, and make decisions based on personal biases
instead of facts.
➢ The study of behavioral finance examines the “less than rational” side of investor
behavior. Bluntly put, behavioral finance seeks to explain people’s behaviors when
it comes to financial decision-making.
➢ Behavioral finance is the study of psychological influences on investors and biases

as they affect the decisions investors make. At its core, behavioral finance is about
identifying and explaining inefficiency and mispricing in financial markets.
➢ As much as everyone seeks to be rational and disciplined, human psychology can make this a
challenge. Investors are not always rational, have limits to their self-control, are
influenced by their own biases, and can make cognitive errors that can lead to
wrong decisions. In other words, investors are normal people.
➢ Fundamentally, behavioral finance is about understanding why and how people make
financial decisions, both individually and collectively. By understanding how investors
and markets behave, it may be possible to modify or adapt to these behaviors to improve
financial outcomes.
Much of behavioral finance research stems from the research in the area of cognitive
psychology.
➢ Cognitive psychology: the study of how people (including investors) think, reason,
and make decisions.
• Reasoning errors are often called cognitive errors.

• Some people believe that cognitive (reasoning) errors made by investors will
cause market inefficiencies.
Cognitive Errors: Heuristics & Biases
Cognitive errors are defined as basic statistical, information processing, or memory

errors that cause a person’s decision to deviate from the rationality assumed in
traditional finance.
These errors fall into two sub-categories:

1. belief preservation errors (the tendency to cling to one’s initial belief even after receiving
new information that contradicts it) and
2. information processing errors (mental shortcuts).
The three major cognitive shortcuts that laid the groundwork of prospect theory are:
1. representativeness (belief preservation),

2. anchoring (information processing), and
3. availability (information processing).
These heuristics influence our judgments, typically subconsciously, and can certainly bias
investment decisions.
NOTE:
These types of behaviors can interfere with, or confuse the best-laid long-term
investment plan. Awareness is the first step toward ensuring behavioral biases do not
compromise sound portfolio management.
Traditional Finance vs. Behavioral Finance
In order to better understand behavioral finance, let’s first look at traditional financial theory.
• Traditional Financial Theory includes the following beliefs:

1. Both the market and investors are perfectly rational.
2. Investors truly care about utilitarian characteristics.
3. Investors have perfect self-control.
4. They are not confused by cognitive errors or information processing errors.
Now let’s compare traditional financial theory with behavioral finance.
• Behavioral Finance Theory

Traits of behavioral finance are:
1. Investors are treated as “normal” not “rational”.
2. They actually have limits to their self-control.
3. Investors are influenced by their own biases.
4. Investors make cognitive errors that can lead to wrong decisions.
History of Behavioral Finance
• Key Figures in the Field
Behavioral finance originated from the work of psychologists Daniel Kahneman and
Amos Tversky and economist Robert J. Shiller in the 1970s-1980s. They applied pervasive,
deep-seated, subconscious biases and heuristics to the way that people make financial
decisions.
According to behavioral economist Herbert Simon, most people use heuristics when
confronted with a complex decision.
Heuristics are mental shortcuts we use to decide on something quickly or not at all.
Three academics, in particular, were leading this shift — Daniel Kahneman, Amos Tversky,
and Richard Thaler. Today, they are known as the “founding fathers of behavioral finance”.
Kahneman and Tversky, who weren’t economists, wrote three groundbreaking papers
from the mid-70s to the early 80s. They were Judgement under Uncertainty: Heuristics and Biases
(1974), Prospect Theory: A Study of Decision Making Under Risk (1979), and The Framing
of Decisions and the Psychology of Choice (1981). These laid the foundation for understanding
biases and their effects on decision-making.
Thaler, a more traditional finance academic, was working with Kahneman and Tversky in
the late 70s and took their ideas and applied them to a finance context. He wrote a paper titled
Toward a Positive Theory of Consumer Choice (1980) that introduced the idea of mental
accounting.
Amos Tversky and Daniel Kahneman, psychologists whose research laid the groundwork
for behavioral economics, concluded after investigating decision-making in a variety of settings, that
many people use heuristics, or mental shortcuts, to arrive at intuitive conclusions based on limitated
and often unreliable information.
When these findings were published in 1973, they evoked outrage in some quarters—and
accusations that Tversky and Kahneman were arrogantly condemning people for not thinking straight.
But further study has confirmed not only the existence of mental shortcuts but also their impact on
decision making.
The Origins Of Behavioral Finance
The origin of behavioral finance can be attributed to the publication of prospect theory in 1979—
the behavioral economist’s replacement for expected utility theory. Prospect theory built on several
previous articles that showcased cognitive shortcuts, also known as heuristics, and their substantial
impact on decision-making. The theory consists of four major components: reference points,
probability weighting, loss aversion, and diminishing sensitivity.
The most salient feature of prospect theory for investment professionals is loss aversion.
Prospect theory asserts that losses loom larger than gains.
Categories Of Errors
• Cognitive errors which cause a person’s decisions to deviate from rationality.
• Belief preservation errors refer to the tendency to cling to one’s initial belief even after
receiving new information that contradicts it.
• Information processing errors refer to mental shortcuts.

• Emotional errors arise as a result of attitudes or feelings that cause one to deviate
from rationality.
Key Concepts
Some key concepts form the basis for how behavioral finance analyzes investors’ behaviors.
• Mental accounting - People place different values on money depending on

subjective criteria including origin, size, and type. People treat certain assets as less
replaceable than others. An example of this is saving up for a new home rather than paying
down credit card debt.
• Emotional Gap - Emotional strains such as anxiety, fear, or excitement disrupt

logical rationally in investment decisions.
An example is rapidly selling off position in a stock after a quick drop in stock price.
• Anchoring - the use of irrelevant information as a reference for evaluating an

unknown value of a financial instrument. Investors who have an anchoring bias
hold on to historical values of financial instruments when making decisions instead
of taking into account current market fundamentals.
An example is buying the stock at $70 and knowing its all-time high was at $100 so the investor
waits until the stock reaches that price again to sell.
• Self-attribution - tendency to be self-confident and disregard knowledge from

others. Attributing success to personal skills and failures to market behaviors, not one’s own.
An example is when an investor thinks they are a genius when they get lucky on a 30% profit on
their stock pick.
Decision-Making Errors and Biases
Let’s explore some of the buckets or building blocks that make up behavioral finance.
Behavioral finance views investors as “normal” but being subject to decision-making biases and
errors. We can break down the decision-making biases and errors into at least four buckets.
#1 Self-Deception
The concept of self-deception is a limit to the way we learn. When we mistakenly think we know
more than we actually do, we tend to miss information that we need to make an informed decision.
#2 Heuristic Simplification
We can also scope out a bucket that is often called heuristic simplification. Heuristic simplification
refers to information-processing errors.
#3 Emotion
Basically, emotion in behavioral finance refers to our making decisions based on our current
emotional state. Our current mood may take our decision-making off track from rational
thinking.
#4 Social Influence
What we mean by the social bucket is how our decision-making is influenced by others.
Awareness of Biases
The following are a few of the biases most common among investors. You may see a bit of yourself
in some of these. Which of these resonate with you?
• Experiential/Recency Bias – the tendency to overemphasize the importance of

recent events or place too much emphasis on experiences that are freshest in your
memory, even if they are not the most relevant or reliable.
It is where the investors’ memory of recent events makes them more likely to believe
the event would happen again in the future.
For example, many investors exited the stock market after the 2008-2009 market collapse in
fear that another harrowing crisis would occur.
This would include being influenced by recent news, events, or experiences. An

example would be expecting a stock price to continue increasing after several quarters of strong
growth in returns without the basis of any solid fundamental analysis. This is also sometimes
referred to as “performance chasing” and can cause an investor to buy or sell at the worst
time.
• Loss aversion bias, also known as Prospect Theory - states that people feel losses more
strongly than equivalent gains.
Loss aversion is a tendency in behavioral finance where investors are so fearful of losses
that they focus on trying to avoid a loss more so than on making gains. The more one
experiences losses, the more likely they are to become prone to loss aversion.
Research on loss aversion shows that investors feel the pain of a loss more than twice as
strongly as they feel the enjoyment of making a profit.
Loss aversion can result in avoiding risk to such a degree that it can lead to an overly
conservative portfolio that cannot meet its long-term financial goals. Loss aversion can
also lead to the decision to sell investments during market downturns simply to
avoid further downturns, which means they could miss out on subsequent gains.
Example: The pandemic sell-off in equity markets during March 2020 is a recent
example. Conversely, loss aversion can result in an investor continuing to hold onto an
investment with negative returns to avoid realizing a loss in their portfolio, even when selling is
the prudent decision.
For example, a loss of $100 hurts more than the delight of a gain of $100.
• Endowment Effect - occurs when an investor values their asset more when they own
it and acts differently depending on the origin of the assets. It refers to peoples’
tendency to ascribe more value to items they own simply because they own them.
For example, an unwillingness to invest inheritance money due to an emotional

familial connection is an example of this bias.
• Overconfidence – the tendency to hold a misleading assessment of one’s skills,

intellect, or talent. It’s an egotistical belief that a person is better than they are.
These individuals often feel they have the ability to make superior decisions regarding
investments or the timing of investments.
A classic example of overconfidence is the fact that the vast majority of people with
driver’s licenses feel they are above-average drivers.
Overconfidence bias is a tendency to hold a false and misleading assessment of our

skills, intellect, or talent. In short, it’s an egotistical belief that we’re better than we
actually are.
NOTE:
The danger of an overconfidence bias is that it makes one prone to making mistakes in
investing. Overconfidence tends to make us less than appropriately cautious in our
investment decisions.
• Herd Mentality – the tendency to follow and copy what other investors are doing
(a.k.a. fear of missing out). Decisions are largely influenced by emotion and
perceived instinct, rather than by independent financial analysis.
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.
The dot com bubble and bitcoin are two examples. Meme stocks would also fall into this
category as these are stocks that experience an increase in volume due to hype on social media
as opposed to company performance. Gamestop is a notable example from earlier this year as
a group of investors drove its price up on social media, putting pressure on short sellers.
• Self serving bias is a tendency in behavioral finance to attribute good outcomes to our
skill and bad outcomes to sheer luck.
Certainly, most of us can think of things that we’ve done and determined that when everything
is going according to plan, it’s clearly due to our skill. Then, when things don’t go
according to plan, clearly we’ve just had bad luck.
One of the most effective ways is by actually recording and recognizing what actually
happened, documenting the reasoning behind your decisions and the outcomes that
followed.
Reviewing a well-kept trading journal can help you easily identify strengths and
weaknesses in your trading. It can also help you identify – and thereby be able to correct –
mistakes that you continually make.
• Confirmation Bias (Finding information that confirms our belief) – is the tendency
of people to pay close attention to information that confirms their belief and ignore
information that contradicts it. Put another way, people tend to cherry-pick
information that supports their existing beliefs.
As an example, a group of friends at a party mention a great investment you should

buy. You are intrigued and search for more information when you get home.
Unfortunately, you are biased by your friends’ comments and unwittingly will focus on the
information you find that supports the investment, placing a lower priority on data that goes
against it.
Another example is that people often seek out information that aligns with their political beliefs
while ignoring information that contradicts those beliefs.
• Hindsight bias is the misconception, after the fact, that one “always knew” that they were
right. Someone may also mistakenly assume that they possessed special insight or talent in
predicting an outcome.
We need to map the outcomes of our decisions and the reasons behind those
decisions to learn from both our wins and our losses. An investment diary also helps
mitigate against the bias of self-deception, which again limits our ability to learn.
• Narrative Fallacy (When stories compromise objective decision making)
One of the limits to our ability to evaluate information objectively is what’s called the narrative
fallacy. We love stories and 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.
Stockbrokers have taken advantage of the narrative fallacy for years, convincing clients to
invest in a stock by telling them a great story about the company.
• Representativeness Heuristic (When the similarity of objects is confused with the

probability of an outcome) - occurs when the similarity of objects or events confuses
people’s thinking regarding the probability of an outcome. People frequently make the
mistake of believing that two similar things or events are more closely correlated
than they actually are.
In financial markets, one example of this representative bias is when investors

automatically assume that good companies make good investments. However, that is
not necessarily the case. A company may be excellent at their own business, but a poor judge of
other businesses.
• Framing Bias (How the way information is presented can influence decisions)
occurs when people make a decision based on the way the information is presented,
as opposed to just on the facts themselves. The same facts presented in two different ways
can lead to people making different judgments or decisions.
NOTE: The key thing is trying to kick in the logical, reflective approach to decision
making and avoid impulsive, reflexive decisions.
• Anchoring bias occurs when people rely too much on pre-existing information or the
first information they find when making decisions.
The anchor – the first thing that you saw – unduly influenced your opinion.
• Conservatism refers to the tendency to insufficiently revise one’s belief when

presented with new evidence. In other words, it occurs when a person overweighs their
prior view and underweights new information. The original information is considered to be more
meaningful and important than the new information, even when there is no rational reason for
this belief.
• Regret Aversion occurs when people fear that their decision will turn out wrong in
hindsight and is associated with risk aversion. Regret is a negative emotion, and anticipating
it may affect behavior as people strive to eliminate or reduce this possibility.
• Status Quo Bias refers to the tendency to prefer that things to stay the same. In other
words, people prefer to keep things the way they are because “it’s always been this way.” In
investing, this can manifest in concentrated stock positions or the tendency to remain invested
in assets that may no longer be appropriate for their portfolio.
• Self-Control Bias When people fail to act in pursuit of their long-term goals because
of a lack of self-control, this is known as self-control bias. For instance, people may consume
more today at the expense of saving for tomorrow. Self-control bias can also be described as the
conflict between one’s long-term goals and one’s ability to pursue it due to a lack of discipline.
NOTE:
Biases such as loss aversion and overconfidence are driven by hard-wired emotions
while the other biases are cognitive and caused by the way people’s brains process
information.
Note: Both emotional and cognitive biases can impact, often negatively, the
achievement of long-term financial objectives.
Overcoming Behavioral Finance Issues
There are ways to overcome negative behavioral tendencies in relation to investing. Here
are some strategies you can use to guard against biases.
#1 Focus on the Process
There are two approaches to decision-making:
• Reflexive – Going with your gut, which is effortless, automatic and, in fact, is our default option.
• Reflective – Logical and methodical, but requires effort to engage in actively.
• Relying on reflexive decision-making makes us more prone to deceptive biases and emotional
and social influences.
Establishing logical decision-making processes can help protect you from such errors.
Get yourself focused on the process rather than the outcome. If you’re advising others, try to
encourage the people you’re advising to think about the process rather than just the possible
outcomes. Focusing on the process will lead to better decisions because the process helps
you engage in reflective decision-making.
#2 Prepare, Plan and Pre-Commit
Behavioral finance teaches us to invest by preparing, by planning, and by making sure we

pre-commit.
Summary
Behavioral finance asserts that investors are human, just like the rest of us. They have emotions
and biases that cloud their rationality. In the world of finance, investors treat their money more
emotionally than rationally and get entangled in a complex web of bias and psychology.
Behavioral finance seeks to understand the psychological basis for people’s behaviors and apply
them to the sphere of money. Behavioral finance ultimately draws ideas from psychology and finance
to generate better insights into how investors can beat their biases and overcome emotions.
You might have heard a common phrase "Even smart people make Big Money mistakes." Well,
this is true Because IQ has nothing to do with money mistakes. It's the heart and emotions that are
essential, explained in different behavioral finance theories.
Behavioral finance suggests that the structure of information and characteristics of participants
of the market can play an essential role in the decision-making of the investor as well as the overall
outcome of the market.
Behavioural Finance is about making the right decisions that are free from any kind of biases
and errors. It helps in understanding investor behavior better and helps in improving the financial
capability of individuals.
People can earn better returns if they know what the biases which are affecting their decision-
making are, and thus they can make better decisions.
It is also helpful in designing wealth management strategies. It is beneficial for portfolio

managers, mutual fund companies, investment consultants, and all those who are guiding people on
how to invest their money.
References
Pompian, Michael M. (2012), Behavioral finance and investor types: managing behavior to make
better investment decisions, John Wiley & Sons, Inc., Hoboken, New Jersey.
Pompian, Michael M. (2006), Behavioral finance and wealth management: building optimal
portfolios that account for investor biases, John Wiley & Sons, Inc., Hoboken, New Jersey.
Ackert, Lucy F., and Deaves, Richard (2010), Behavioral Finance: Psychology, Decision-Making,
and Markets, South-Western Cengage Learning, 5191 Natorp Boulevard Mason, OH 45040,
USA.
Burton, E. T., & Shah, S. N. (2013). Behavior finance: Understanding the social, cognitive, and
economic debates. New Jersey: John Wiley & Sons, Inc.
Copur, Z. (2015). Handbook of research on behavioral finance and investment strategies:

Decision making in the financial industry. USA: IGI Global.
Kaplan Financial Education (2021), What is Behavioral Finance?

https://www.kaplanfinancial.com/resources/career-advancement/behavioral-finance
Kaur, Rashmeet (2020), What is Behavioral Finance and how does it affect your Financial
decisions? https://insider.finology.in/behavioral-finance/what-is-behavioral-finance
Golovaty, Kevin and Gupta, Rohan (2020), Introduction to Behavioral Finance,

https://streetfins.com/intro-to-behavioral-finance/
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-
finance/
Adair, Michael O. (2018), Behavioral Finance: Understanding How Biases Impact Decisions.
https://www.cnr.com/insights/article/white-paper-behavioral-finance-2018.html
Tanvi, Chawda (2020), Behavioral Finance. http://www.imit.ac.in/note/18MBA402Bbf.pdf
posting online in any form or by any means without the written permission of the University is strictly prohibited. i
posting online in any form or by any means without the written permission of the University is strictly prohibited. ii
posting online in any form or by any means without the written permission of the University is strictly prohibited. iii
posting online in any form or by any means without the written permission of the University is strictly prohibited. iv
posting online in any form or by any means without the written permission of the University is strictly prohibited. v
posting online in any form or by any means without the written permission of the University is strictly prohibited. ix

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PBSBAFM006 – BEHAVIORAL FINANCE

MODULE 1 - Introduction to Behavioral Finance

Intended Learning Outcomes

1. Introduction to Behavioral Finance

INTRODUCTION TO BEHAVIORLA FINANCE

What is behavioral finance how does it affect your financial decisions?

In simple terms, Behavioral Finance is: Psychology + Finance

Psychology is the study of mind and behavior. It encompasses the biological

Finance is defined as the management of money and includes activities such as

The behavioral economic theory states that:

➢ Markets are inefficient.

Building blocks of Behvioral Finance:

• Limits to arbitrage refers to predicting in what circumstances arbitrage forces will

Definitions of Behavioral Finance

➢ Behavioral finance is the study of the effects of psychology on investors and

➢ Behavioral finance is the study of psychological influences on investors and biases

• Reasoning errors are often called cognitive errors.

Cognitive Errors: Heuristics & Biases

Cognitive errors are defined as basic statistical, information processing, or memory

These errors fall into two sub-categories:

1. representativeness (belief preservation),

Traditional Finance vs. Behavioral Finance

• Traditional Financial Theory includes the following beliefs:

Now let’s compare traditional financial theory with behavioral finance.

• Behavioral Finance Theory

History of Behavioral Finance

• Key Figures in the Field

The Origins Of Behavioral Finance

• Information processing errors refer to mental shortcuts.

• Mental accounting - People place different values on money depending on

• Emotional Gap - Emotional strains such as anxiety, fear, or excitement disrupt

• Anchoring - the use of irrelevant information as a reference for evaluating an

• Self-attribution - tendency to be self-confident and disregard knowledge from

Decision-Making Errors and Biases

• Experiential/Recency Bias – the tendency to overemphasize the importance of

This would include being influenced by recent news, events, or experiences. An

For example, an unwillingness to invest inheritance money due to an emotional

• Overconfidence – the tendency to hold a misleading assessment of one’s skills,

Overconfidence bias is a tendency to hold a false and misleading assessment of our

As an example, a group of friends at a party mention a great investment you should

• Narrative Fallacy (When stories compromise objective decision making)

• Representativeness Heuristic (When the similarity of objects is confused with the

In financial markets, one example of this representative bias is when investors

• Conservatism refers to the tendency to insufficiently revise one’s belief when

Overcoming Behavioral Finance Issues

#1 Focus on the Process

There are two approaches to decision-making:

#2 Prepare, Plan and Pre-Commit

Behavioral finance teaches us to invest by preparing, by planning, and by making sure we

It is also helpful in designing wealth management strategies. It is beneficial for portfolio

Copur, Z. (2015). Handbook of research on behavioral finance and investment strategies:

Kaplan Financial Education (2021), What is Behavioral Finance?

Golovaty, Kevin and Gupta, Rohan (2020), Introduction to Behavioral Finance,

Tanvi, Chawda (2020), Behavioral Finance. http://www.imit.ac.in/note/18MBA402Bbf.pdf

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