Unit – II

building blocks of behavioral finance

 Behavioural finance meaning
• Behavioural finance is the study of the influence
of psychology on the behaviour of financial
practitioners and the subsequent effect on
market.
• According to behavioural finance, investors’
market behaviour derives from psychological
principles of decision-making to explain why
people buy or sell stock.
• Behavioural finance focuses upon how investor
interprets and acts on information to take various
investment decisions
Two building blocks of Behavioural
finance

Behavioural
finance

Limits to arbitrage
Cognitive psychology
(when markets will
( How people think ?)
inefficient ?)
Cognitive psychology
It is scienitify study of
Why to study cognitive psychology
• Understand the mind
• Education
• Therapy
• Artificial intelligence
• Entertainment
• Gaming etc.
Advantage of cognitive psychology
• Scientific
• Highly applicable
• Combines easily with approach
• Many empirical studies to support theories.
 Disadvantage of cognitive psychology
• Ignores boilogy
• Experiments
• Behaviorism
• Humanism
 Limits of arbitrage
• Theory which assumes that restrictions placed
upon funds, that would ordinarily be used by
relational traders to arbitrage away pricing
inefficiencies
• Always costly
• Can’t perfectly move on inflated prices
• Increase market efficiency.
 Definition of Arbitrage
• Simultaneous buying and selling of same or
substitutes securities in different markets to
benefit from mispricing.
• Very experienced investors