Introduction

OUTLINE to
Behavioral Finance
◦ Definition of Behavioral Finance
◦ Foundation of Behavioral Finance
◦ History of Behavioral Finance
◦ Scope of Behavioral Finance
◦ Behavioral Finance Concepts

Christian Neil A. Ramos, MBA, CIA

Faculty, BSBA – Financial Management
OUTLINE

◦ Definition of Behavioral Finance

◦ Foundation of Behavioral Finance
◦ History of Behavioral Finance
◦ Scope of Behavioral Finance
◦ Behavioral Finance Concepts
Behavioral Finance

◦ Behavioral finance is the study of the influence of psychology on the behavior of investors or
financial analysts. It also includes the subsequent effects on the markets. It focuses on the fact
that investors are not always rational, have limits to their self-control, and are influenced by
their own biases.
Behavioral Finance

M. Schindler (2007) has given certain examples while defining behavioral finance:

(a) Investors’ biases when making decisions and thus letting their choices be influenced by
optimism, overconfidence, and conservatism.
(b) Experience and heuristics help in making complex decisions.
(c) The mind processes available information, matching it with the decision’s maker own frame
of reference, thus letting the framing by the decision maker impact the decision.
Foundation of Behavioral Finance

◦ Psychology
In behavioral finance, we study the impact of a person’s attitude, emotions, and mindset over his/her investing
decisions.

◦ Sociology
It emphasizes the effect of social relations and the conduct of an individual while being in a group or a society
over his/her decision-making ability.

◦ Finance
The sum available with the investor, price and future value of the security also influences the capital allocation
functions.
Foundation of Behavioral Finance

As detailed in Finance for Normal People, standard finance is built on five foundation blocks:
1. People are rational.
2. People construct portfolios as described by mean–variance portfolio theory, where people’s portfolio
wants to include only high expected returns and low risk.
3. People save and spend as described by standard life-cycle theory, where people find it easy to identify
and implement the right way to save and spend.
4. Expected returns of investments are accounted for by standard asset pricing theory, where differences in
expected returns are determined only by differences in risk.
5. Markets are efficient, in the sense that price equals value for all securities and in the sense that markets
are hard to beat.
Foundation of Behavioral Finance

Second-generation behavioral finance offers an alternative foundation block for each of the five
foundation blocks of standard finance, incorporating knowledge about people’s wants and their
cognitive and emotional shortcuts and errors. According to second-generation behavioral finance,

1. People are normal.

2. People construct portfolios as described by behavioral portfolio theory, where people’s portfolio wants to
extend beyond high expected returns and low risk, such as wants for social responsibility and social status.
Foundation of Behavioral Finance

3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak
self-control, make it difficult to save and spend in the right way.
4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences
in expected returns are determined by more than just differences in risk—for example, by levels of social
responsibility and social status.
5. Markets are not efficient in the sense that price always equals value in them, but they are efficient in the
sense that they are hard to beat.
History of Behavioral Finance

◦ Behavioral finance has informal origins dating back to Selden's 1912 Psychology of the Stock Market, as
well as Fessinger's 1956 study of cognitive dissonance and Pratt's 1964 discussion of risk aversion and
the utility function.
◦ However, the official start of behavioral finance is arguably 1979, which marks the release of Daniel
Kahneman's and Amos Tversky's Prospect Theory: A Study of Decision Making Under Risk.
◦ Kahneman and Tversky were shortly thereafter joined by a third so-called founding father, Richard
Thaler. In 1980, Thaler published a paper about investors' propensity towards mental accounting, a
phenomenon wherein they tended to view their money as being in separate and disparate pools
depending on function (retirement fund, vs. emergency fund vs. college fund, etc.).
History of Behavioral Finance

◦ Together, Thaler, Kahneman, and Tversky began a robust body of literature on how people make
financial decisions, using psychology to bridge the gap between real life and classic economic theory.

The bottom line is that behavioral finance is a rich area of study, rife with implications for financial
advisors and their clients. However, understanding this broader landscape will hopefully allow us to see the
bigger picture when diving down some of the specific behavioral rabbit holes in the coming weeks.
Scope of Behavioral Finance

◦ Investors. Behavioral finance is a means to analyze the common mistakes which investors make while
selecting particular security
◦ Corporations. Behavioral finance studies the impact of the mindset of financial advisors, directors and
managers that influence corporate investment decisions.
◦ Markets. When it comes to stock price analysis and speculation, behavioral finance trends are widely
applicable.
◦ Regulators. The financial regulators consider behavioral finance as a means to refrain market failure and
future crisis by transforming the market players’ attitudes towards certain security.
◦ Educators. For educators and teachers, behavioral finance helps to depart knowledge on rational
decision-making and elaborate the psychological barriers which hinder the process
Behavioral Finance Concepts

◦ Mental accounting. Refers to the propensity for people to allocate money for specific purposes.

◦ Herd behavior. States that people tend to mimic the financial behaviors of the majority of the herd.
Herding is notorious in the stock market as the cause behind dramatic rallies and sell- offs.

◦ Emotional gap. Refers to decision making based on extreme emotions or emotional strains such as
anxiety, anger, fear, or excitement.
Behavioral Finance Concepts

◦ Anchoring. Refers to attaching a spending level to a certain reference

◦ Self-attribution. Refers to a tendency to make choices based on a confidence in self-based knowledge.

Self-attribution usually stems from intrinsic confidence of a particular area.
THANK YOU!!!