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Chapter 1

Behavioral Finance
Learning Objectives

Explain Behavioral finance as


Modern Finance
Explain the Nature and Scope of
Behavioral Finance
Describe the Objectives of Behavioral
Finance
Explain the history of Behavioral
Finance
Behavioral Finance: Introduction

Behavioral Finance is a concept developed with the inputs taken


from the field of psychology and finance, which tries to understand
various puzzling observations in stock markets with better
explanations.

Nature
Behavioral Finance is just not a part of finance. It is something which
is much broader and wider and includes the insights from behavioral
economics, psychology and microeconomic theory.
The main theme of the traditional finance is to avoid all the possible
effects of individuals personality and mindset

Behavioral finance is divide it into two branches.


Micro Behavioral Finance
Macro Behavioral Finance
Behavioral Finance: Introduction

Behavioral Finance as a Science


Behavioral Finance as an Art
Scope
To understand the Reasons of Market Anomalies:
To Identify Investors Personalities
Helps to identify the risks and their hedging
strategies
Provides an explanation to various corporate
activities
To enhance the skill set of investment advisors
Behavioral Finance: Introduction

Objectives
To review the debatable issues in Standard Finance and the
interest of stakeholders.
To examine the relationship between theories of Standard
Finance and Behavioral Finance.
To examine the various social responsibilities of the subject.
To discuss emerging issues in the financial world.
To discuss the development of new financial instruments
To get the feel of trend of changed events over years, across
various economies.
To examine the contagion effect of various events.
An effort towards more elaborated identification of investors
personalities.
More elaborated discussion on optimum Asset Allocation
Behavioral Finance: The Traditional View to Financial Markets

Weak Form Semi Strong Form Strong Form

Historical Information is available Stock prices adjust all publically All information is fully reflected in
Future prices of stocks can not be available information the stock prices
predicted Few Insiders earn profits, who adjust Investors respond quickly
Technical Analysis is of little or no their decision making according to Insider information is of no value
value available information
Fundamental Analysis is of little or
no value
Behavioral Finance: Limitations of Efficient Market Hypothesis

Market imperfections, like delay in information and


Transaction Costs are unexplained.
EMH deals with absolute price changes but not the
relative price changes of the stocks.
Random movement of stock prices does not indicate
the direction of movement.
Other prevalent market anomalies like Low PE
effect, Small firm Effect and The weekend Effect
shows significant deviation from the Efficient Market
hypothesis , hence calls for a need of Behavioral
Finance.
Behavioral Finance: Standard Finance versus Behavioral
Finance

Standard Finance Behavioral Finance

Standard Finance believes in existence of Rational Markets and Behavioral Finance believe in existence of irrational markets and
Rational investors irrational Investors

Standard helps in building a rational portfolio Behavioral finance helps in building an optimal portfolio

Standard Finance theories rest on the assumptions that Explanations of behavioral finance are in light with the real
oversimplify the real market conditions problems associated with human psychology

Standard Finance explains how investor should behave Behavioral Finance explains how does investor behave

Standard Finance assumptions believe in idealized financial Behavioral finance assumptions believe in observed financial
behavior behavior