BEHAVIORAL

FINANCE
By
Sudeshna Dutta
Assistant Professor
BIITM
 Behavioural Finance
It's hard not to think of the stock market as a person
 It has moods that can turn from irritable to euphoric;
 it can also react hastily one day and make amends the next.
But can psychology help us understand financial markets?
Does analyzing the mood of the market provide us with any hands-on
strategies? 
Behavioral finance theorists suggest that it can.
Introduction
• Since the mid-1950s, the field of finance has been dominated by the traditional finance
model developed by the economists of the University of Chicago.
• Standard Finance theories are based on the premise that investor behaves rationally and
stock and bond markets are efficient.
• Central assumption of the traditional finance model is that the people are rational.
• Cognitive error and extreme emotional bias can cause investors to make bad investment
decisions, thereby acting in irrational manner.
• Since the past few decade, field of Behavioural finance has evolved to consider how personal
and social psychology influence financial decisions and behaviour of investors in general.
• . The finance field was reluctant to accept the view of psychologists who had proposed the
Behavioural finance model. Behavioural finance was considered first by the psychologist
Daniel Kahneman and economist Vernon Smith, who were awarded the Nobel Prize in
Economics in 2002
What is Behavioural Finance
• Behavioural finance is a concept developed with Click icon to add picture
the inputs taken from the field of psychology and
finance.
• It tries to understand the various puzzling factors in
stock markets to offer better explanations for the
same.
• To answer the increased number and types of
market anomalies, a new approach to financial
markets had emerged- the Behavioural finance.
• Behavioural finance is defined as the study of the
influence of socio-psychological factors on an
asset’s price. It focuses on investor behavior and
their investment decision-making process.
• 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 biase.
 Behavioural 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.
• The emotional gap refers to decision making based on extreme
emotions or emotional strains such as anxiety, anger, fear, or
excitement. Oftentimes, emotions are a key reason why people do
not make rational choices.
• Anchoring refers to attaching a spending level to a certain reference.
Examples may include spending consistently based on a budget level
or rationalizing spending based on different satisfaction utilities.
• 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. Within this category,
individuals tend to rank their knowledge higher than others.
 Nature of Behavioural Finance
• Heuristics / Information processing errors : Heuristics are referred as
rule of thumb, which applies in decision making to reduce the
cognitive resources to solve a problem. These are mental shortcuts Heuristics
that simplify the complex methods to make a judgment.
• Framing: The perceptions of choices that people have are strongly
influenced by how these choices are framed. It means choices
depend on how question is framed, even though the objective facts
remain constant
• Emotions: Emotions and associated human unconscious needs,
fantasies, and fears drive much decision of human beings. How
Framing
BF Market
Impact
these needs, fantasies, and fears influence financial decision?
Behavioural finance are cognise the role Keynes’s“animal spirit”plays
in explaining investor choices, and thus shaping financial markets
• Market Impact: Indeed, main attraction of behavioural finance field
was that market prices did not appear to be fair. How market
anomalies fed an interest in the possibility that they could be Emotions
explained by psychology?
SCOPE OF BEHAVIOURAL FINANCE
• To understand the reasons of market anomalies: Though standard finance theories
are able to justify the stock market to a great extent, still there are many market
anomalies that take place in stock markets, including creation of bubbles, the effect
of any event, calendar effect on stock market trade etc. These market anomalies
remain unanswered in standard finance but behavioral finance provides
explanation and remedial actions to various market anomalies.
• To identify investor’s personality: An exhaustive study of Behavioural finance helps
in identifying the different types of investor personality. Once the biases of the
investor’s actions are identified, by the study of investor’s personality, various new
financial instruments can be developed to hedge the unwanted biases created in
the financial markets.
• Behavioural finance provides explanation to various corporate activities
SCOPE OF BEHAVIOURAL FINANCE
• To enhance the skill set of investment advisors: This can be done by providing
better understanding of the investor’s goals, maintaining a systematic approach
to advise, earn the expected return and maintain a win-win situation for both the
client and the advisor
• Helps to identify the risks and develop hedging strategies: Because of various
anomalies in the stock markets, investments these days are not only exposed to
the identified risks, but also to the uncertainty of the return
 Differences between Standard Finance and Behavioural
Finance

1. Traditional finance assumes that people process data 1. Behavioural finance recognizes that people employ
appropriately and correctly imperfect rules of thumb (heuristics) to process data
which induces biases in their belief and predisposes
2. Traditional Finance presupposes that people view all them to commit errors.
decision through the transparent and objective lens of
risk and return 2. Behavioural finance postulates that perceptions of
risk and return are significantly influenced by how
3. Traditional finance assumes that people are guided by decision problem is framed
reasons and logic and independent judgment
3. Behavioural finance, recognises that emotions and
4. Traditional finance argues that markets are efficient, herd instincts play an important role in influencing
implying that the price of each security is an unbiased decisions.
estimate of its intrinsic value.
4. Behavioural finance contends that heuristic-driven
biases and errors, frame dependence, and effects
emotions and social influence often lead to
discrepancy between market price and fundamental
value.
 Significance of Behavioural Finance
Trivia : The Boston-based Dalbar in its 2007 report “Quantitative Analysis of Investor
Behaviour ” found that in the past 20 years the American S&P 500 Index returned on
average11.8% pa, while the average investor earned 4.3 % pa–substantially lower returns.
• The main reasons for the variance were the tendency for the average investor to sell after a
stock price has fallen along way and then buy back in to the market after it has already
risen a large amount. Effectively the average investor is buying high and selling low, and
thus making losses.
 Significance of Behavioural Finance
• Behavioural Finance seeks to account for this behavior, and covers the rationality or
otherwise of people making financial investment decisions. Understanding
Behavioural Finance helps us to avoid emotion-driven speculation leading to losses,
and thus devise an appropriate wealth management strategy.
• Behavioural Finance covers “individual and group emotion, and behaviour in markets.
The field brings together specialists in personality, social, cognitive and clinical
psychology; psychiatry; organizational
behaviour;accounting;marketing;sociology;anthropology;behavioural economics
;finance and the multidisciplinary study of judgment and decision making”.
What is Expected Utility?

• Expected utility is a theory in economics that estimates the utility of an action when the outcome is
uncertain.
• It advises choosing the action or event with the maximum expected utility. At any point in time, the expected
utility will be the weighted average of all the probable utility levels that an entity is expected to reach under
specific circumstances.
• The expected utility theory considers it a logical choice to choose the event with the maximum expected
utility. However, in case of risky outcomes, decision-makers may not choose the action with a higher
expected utility. The decision to choose an action will also depend on the entity’s risk aversion and other
entities’ utility. While some entities choose the option with the riskier highest expected utility, some highly
risk-averse entities prefer the low-risk option even if it shows a lower expected value.
• Expected utility theory also helps to explain the reason for people taking out insurance policies. It is a
situation where the payback is not immediate; however, insurance policies cover individuals for several
risks. Insurance policyholders receive tax benefits and a certain income at the expiry of a predetermined
period. Hence, when one compares the expected utility to be received from paying insurance premiums
with the expected utility of investing the amount on other products, insurance appears to be a better choice.
What is Expected Utility?

• The concepts of marginal utility and expected utility are related. The expected
utility of wealth or a reward reduces when the entity possesses sufficient wealth.
Such entities may go for the safer alternative instead of the riskier ones.
• The addition of $1,000 to the income may not impact the marginal utility of two
different entities in the same way. For example, if the annual income of a low-
earning family is increased from $1,250 to $2,250, it will improve their quality of
life as well as the marginal utility. On the contrary, if the income of a high-earning
family increases from $120,000 to $121,000 in a year, there is a very small utility
improvement.
•