Basics 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 individual’s personality and mindset

Behavioral finance is divide it into two branches.

• Micro Behavioral Finance
• Macro Behavioral Finance
 Behavioral Finance: History

Behavioral Approach is an approach to understand the movements in financial markets,

which is contrary to Efficient market Hypothesis (EMH), which has been the key
preposition of traditional finance, which believed that the financial markets are
efficient and highly analytical. Fama defined efficient markets are those markets in
which, “ Security prices always fully reflect the available information.”

classical view, Behavioral finance assumes that the irrational behavior of investor
advisors and due to combined and multiplied effect of investor’s personalities,
markets will not always be efficient. This inefficiency of financial markets causes
the stock prices to deviate from the predictions of traditional market models.
 Behavioral Finance: Major contributors in Behavioral Finance

• Alan Greenspan, the Federal Reserve Chairman for raising concern for Irrational
exuberance with respect to Japan in his lecture in 1996.
• Professor Richard Thaler, from University of Chicago Graduate Schoolof Business,
studied investors behavior responsible for the creation of Tech Bubble.
• Professor Hersh Shefrin from University in Santa Clara, California contributed in the
field by writing the book “Beyond Greed and Fear : Understanding behavioral
Finance and the Psychology of Investing”.
• Professor Kahneman and Amos Tversky formulated the Prospect Theory. As a
alternative to standard finance, prospect theory described thet the human judgements
are influenced by Heuristic and disagree with the basic principles of probability
 Behavioral Finance: The Traditional View to Financial Markets

Weak Form Semi Strong Form Strong Form

 Historical Information is  Stock prices adjust all  All information is fully

available
 Future prices of stocks can
not be predicted
 Technical Analysis is of
little or no value
publically available reflected in the stock prices
information  Investors respond quickly
 Few Insiders earn profits,  Insider information is of no
who adjust their decision value
making according to
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 Behavioral Finance believe in existence of irrational
Markets and Rational investors markets and irrational Investors

Standard helps in building a rational portfolio Behavioral finance helps in building an optimal
portfolio
Standard Finance theories rest on the assumptions Explanations of behavioral finance are in light with
that oversimplify the real market conditions the real problems associated with human
psychology
Standard Finance explains how investor “should” Behavioral Finance explains how “does” investor
behave behave
Standard Finance assumptions believe in idealized Behavioral finance assumptions believe in observed
financial behavior financial behavior