Behavioral Finance

Unit 1
Syllabus:
Behavioural Finance: Nature, Scope, Objectives and Significance & Application.
History of Behavioural
Finance, Psychology: Concept, Nature, Importance, The psychology of financial
markets, The psychology of
investor behaviour, Behavioural Finance Market Strategies, Prospect Theory, Loss
aversion theory under
Prospect Theory & mental accountinginvestors Disposition effect

Course Objective

To understand the basic meaning of the subject behavioural finance

To understand the investors psychology
Market strategies
Theories of behavioural finance
 Behavioral Finance: Meaning

Behavioural finance is the study of the influence of psychology on the

behavior of financial practitioners and the subsequent effect on markets.

Behavioural finance is of interest because it helps explain why and how

markets might be inefficient.
 Nature of Behavioral Finance

Most people know that emotions affect investment decisions. People in the
industry commonly talk about the role greed and fear play in driving stock
markets. Behavioural finance extends this analysis to the role of biases in
decision making, such as the use of simple rules of thumb for making
complex investment decisions.
Behavioural finance takes the insights of psychological research and
applies them to financial decision
 Nature of Behavioral Finance

Behavioural finance studies the psychology of financial

decision-making.
It makes the understanding of investment decision.
It is the study of investors psychology.
It is analytical in nature.
 Scope
Identify Investors Personality
Helps to identify risk
Provides explanations to various corporate
activities
Enhance the skill set to investment advisors
To understand the market anamalities
Objective of Behavioural Finance
To study emerging issues in financial
market
To understand the psychology of the
investors
To study the change in trends in investment
Objective of Behavioural Finance

To study the investment decision

Develop the strategy of financial decision
Study the scope of investment decision
 Psychology
Psychology is concerned with all aspects of
behaviour and with the thought, feelings,
and motivation underlying that behaviour
Psychology is defined as the scientific study
of human behaviour with the object of
understanding why living being behave as
they do.
 Scope of Psychology
Social Psychology
Behavioural Psychology
Applied Psychology
Educational Psychology
 Nature of psychology
Psychology as science
Psychology as social science
Psychology as positive science
Psychology as applied science
 Psychology of financial market
Market psychology
Boom and cycles
Psychology of investors
Psychology of the rational man
 Psychology of investors
behaviour
Behavioural approach
Cognitive approach
Psychoanalytic approach
Humanistic approach
Eclectic approach
 Behavioural finance: Market
strategy
Market timing
Buy and hold strategy
Technical analysis as tool
Behavioural indicators
Psychology of financial market:

Modern investment theory says that, at all times, market prices

equal fundamental value and that asset returns in the cross-
section reflect relative exposures to systematic non-diversifiable
risk. Despite decades of data analysis, empirical support for this
theory remains thin.
 Prospect Theory
The theory states that people make decisions based on the potential value
of losses and gains rather than the final outcome, and that people evaluate
these losses and gains using certain heuristics.

The foundation of prospect theory is that investors are much more

distressed by prospective losses than they are happy about prospective
gains.
 Loss aversion theory

In economics and decision theory, loss aversion refers to people's

tendency to strongly prefer avoiding losses to acquiring gains.

Most studies suggest that losses are twice as powerful,

psychologically, as gains.

This leads to risk aversion when people evaluate an outcome

comprising similar gains and losses; since people prefer avoiding
losses to making gains.
 Mental Accounting
Mental accounting theory, framing means that the way a
person subjectively frames a transaction in their mind will
determine the utility they receive or expect.
It is a tendency of the brain to create short cuts with how it
perceived the information and ending up with outcomes
that is difficult to be viewed in any other way. The results
of these mental accounting are that it influence decisions
in unexpected ways
 Investors Disposition Effect

The disposition effect is an anomaly discovered

in behavioral finance. It relates to the tendency of investors
to sell shares whose price has increased, while keeping
assets that have dropped in value.
 Investors Disposition Effect

Investors are less willing to recognize losses (which they

would be forced to do if they sold assets which had fallen
in value), but are more willing to recognize gains. This is
irrational behavior, as the future performance of equity is
unrelated to its purchase price.