CHAPTER 1

BEHAVIORAL FINANCE:
INTRODUCTION
LEARNING OUTCOMES
◼ Explain the concept of behavioral finance
◼ Describe an Efficient Market Hypothesis and its
variations
◼ Identify the key themes in behavioral finance
◼ Differentiate standard (traditional) and behavioral
finance.
• “The investor’s chief problem, and even his worst
enemy, is likely to be himself.” – Benjamin Graham
• “There are three factors that influence the market:
Fear, Greed, and Greed.” – Market Folklore
• Sooner or later, you are going to make an investment
decision that winds up costing you a lot of money.
• Why is this going to happen??
• You made a sound decision, but you are “unlucky”.
• You made a bad decision – one that could have been
avoided.
• The beginning of investment wisdom:
• Learn to recognize circumstances leading to poor decisions.
• Then, you will reduce the damage from investment
blunders.
INTRODUCTION
• Behavioral finance is a relatively new field in economics that has become
a “hot topic” for investment professionals.
• For example, a large number of conferences oriented toward investors
have recently featured sessions on behavioral finance. However, because
the field is so new, most professionals responsible for large portfolios
were not exposed to the principles of behavioral finance in their college
curricula and these principles have significant practical implications for
investment management.
• Behavioral finance has recently become a subject of significant interest
to investors. Because it is a relatively new and evolving field in
economics and consequently not well defined, a legitimate question is:
WHAT EXACTLY IS BEHAVIORAL FINANCE?
• Behavioral finance can be described in the following ways:
• Behavioral finance is the integration of classical economics and
finance with psychology and the decision-making sciences.
• Behavioral finance is an attempt to explain what causes some of the
anomalies that have been observed and reported in the finance
literature.
• Behavioral finance is the study of how investors systematically make
errors in judgment, or “mental mistakes.”
• All economic models make simplifying assumptions about
both market conditions and the behavior of market
participants. Sometimes the simplifying assumptions
underlying the model are explicitly stated and sometimes
the assumptions are implicit – the latter is often the case
regarding the behavioral assumptions underlying the
model.
• To illustrate, consider the efficient market hypothesis (EMH), an
economic model of considerable importance to investors. The
simplifying assumptions regarding market conditions that underlie
the EMH frequently include, among others, assumptions such as:
• Transaction costs are zero.
• Markets are not segmented.
• Easy (even unlimited) entry into the security markets exists.
• The behavioral assumptions that underlie the EMH can be expressed
as:
• Investors act, in an unbiased fashion, to maximize the value of their
portfolios.
• Investors always act in their own self-interest. The first
behavioral assumption is frequently stated as “rational
expectations wealth maximizes” – this means that investors
form unbiased expectations of the future and given these
expectations, they buy and sell in the securities markets at
prices which they believe will maximize the future value of their
portfolios.
• Behavioral finance questions whether the behavioral
assumptions underlying the EMH are true. For example,
consider the assumption that individuals always act in their
economic self-interest. Suppose you are having dinner at an out-
of-town restaurant and it is extremely unlikely that you will ever
return to this restaurant. Do you leave a tip?
• Most people do, but in this case leaving a tip decreases, rather
than increases one’s wealth, and because you won’t be
returning to this restaurant there are (presumably) no “costs”
associated with not leaving a tip. In this case leaving a tip
violates the rational expectations and self-interest assumptions.
• More pertinent to the EMH, consider “social investing” such as
arbitrarily deciding not to invest in tobacco stocks or deciding to
overweight environmentally clean industries, etc. Such behavior
is not consistent with pure wealth maximization, if for no other
reason than opportunities for forming better-diversified
portfolios are foregone.
• Why investors might engage in non-wealth maximizing behavior,
and what are the implications of such behavior for security
pricing, are areas of inquiry in behavioral finance.
• Another aspect of behavioral finance concerns how investors
form expectations regarding the future and how these
expectations are transformed into security prices.
• Researchers in cognitive psychology and the decision sciences
have documented that, under certain conditions, people
systematically make errors in judgment or mental mistakes.
These mental mistakes can cause investors to form biased
expectations regarding the future that, in turn, can cause
securities to be mispriced.
• By considering that investors may not always act in a wealth
maximizing manner and that investors may have biased
expectations, behavioral finance may be able to explain some of
the anomalies to the EMH that have been reported in the
finance literature.
• Anomalous returns such as those associated with “value” stocks,
earnings surprises, short-term momentum and long-term price
reversals are fertile ground for researchers in behavioral finance.
• The debate in theoretical finance between the efficient market
hypothesis and the field of the behavioral finance is of great
interest. Since its emergence, the efficient market hypothesis has
been the most important theory that explains the behavior of the
various agents in the financial markets and neglects almost any
potential impact of human behavior in the investment process.
• However, from the end of 1970s and the beginning of1980s a
growing number of researchers showed the anomalies of this
theory. The anomalies of the modern portfolio models have
prompted the development of what is now known as behavioral
finance.
• Behavioral finance integrates psychology and economics in finance
theory and has its roots in the pioneering work of psychologists
EFFICIENT MARKET HYPOTHESIS
• The Efficient Market Hypothesis (EMH), introduced by Markowitz in 1952 and
subsequently named by Fama in 1970 assumes that financial markets
incorporate all public information and asserts that share prices reflect all
relevant information.
• Despite the emphasis on the EMH in finance, there seems to be increasing
evidence of substantial anomalies in financial markets. These suggest that
the underlying principles of rational behavior underpinning the EMH may, in
fact, be flawed.
• Some therefore have begun to look at other elements present in financial
markets, including human behavior.
• In fact, the assumptions underlying modern portfolio theory have been shown to
be inconsistent with individual investor behavior. The anomalies of the modern
portfolio models have prompted the development of what is now known as
behavioral finance.
• The behavioral finance literature falls into two primary areas: the identification
of―anomalies in the efficient market hypothesis that behavioral models may
explain and the identification of individual investor behaviors or biases inconsistent
with classical economic theories of rational behavior.
• Behavioral finance thus challenges the efficient markets perspective and focuses
upon how investors interpret and act upon information freely available to them.
• If helps us better understand the investors’ behavior and real market practices.
• It thus can help investors make better investment decisions in the very complex and
complicated financial market places.
• Behavioral Finance is the study of the influence of psychology on the
behavior of financial practitioners and the subsequent effect on markets.
• Behavioral Finance is of interest because it helps explain why and how
markets might be inefficient.
• Behavioral researchers have described the direction of behavioral
research as follows:
• We have now begun the important job of trying to document and
understand how investors, both amateurs and professionals, make their
portfolios choices.
• Until recently such research was notably absent from the repertoire of
financial economists, perhaps because of the mistaken belief that asset
pricing can be modeled without knowing anything about the behavior of
the agents in the economy.
FOUNDATION AND LIMITS OF EFFICIENT
MARKET HYPOTHESIS
• Standard finance is the body of knowledge built on the
pillars of the arbitrage principles of Modigliani and Miller,
the portfolio principles of Markowitz, the capital asset
pricing theory of Sharpe and the option-pricing theory of
Black, Scholes and Merton (Statman, 1999). The efficient
market hypothesis is the most prominent financial theory.
 FOUNDATION AND LIMITS OF EFFICIENT
MARKET HYPOTHESIS
Foundation Of The Efficient Market Hypothesis
• Theoretically, the EMH rests on three basic assumptions:
• 1. Market actors are perfectly rational and are able to value securities
rationally, which means rational investors value each security for its
fundamental value that can be defined by the net present value of its future
cash flows discounted by a risk factor. This implies that the security price fully
reflects all the available information, and, consequently, that in the prices
formation all the relevant information is valued properly.
• 2. Even if there are some investors who are not rational, their trading activities
will either cancel out with one another or will be arbitraged away by rational
investors
• 3. Market actors have well defined subjective utility functions which they will
maximize.
 FOUNDATION AND LIMITS OF EFFICIENT
MARKET HYPOTHESIS
The assumptions underlying the subjective expected theory are:
▪ The decision maker has a well-defined utility function which can be
assigned some cardinal number to reflect the possible future events;
▪ Rationality denotes a style of behavior that is appropriate to the
achievement of given goals, within the limits imposed by given
conditions and constraints.
▪ The decision maker faces a well-defined set of alternatives to choose
from;
o The decision maker is able to assign a consistent joint probability
distribution to all future sets of events;
o The decision maker will maximize the expected value of his/her utility
function.
 FOUNDATION AND LIMITS OF EFFICIENT
MARKET HYPOTHESIS
Limits of the Efficient Market Hypothesis
The Bounded Rationality
• The investors’ deviations from the maxims of economic rationality are
pervasive and systematic. Behavioral theorists argue that rational
efficient market is not consistent with empirical findings on abnormal
stock returns for stocks with high current earnings yields, high book-to-
price ratios, shortterm price momentum and long-term reversal and
excessive price volatility. In reality, when risk and uncertainty or
incomplete information about an alternative or high degree of
complexity is introduced, people or organizations may behave
somewhat different from rationality. This is called bounded rationality.
 FOUNDATION AND LIMITS OF EFFICIENT
MARKET HYPOTHESIS
Limits of the Efficient Market Hypothesis
The Bounded Rationality
• So investors tend to deviate from rationality because of their attitudes
toward risk and to their sensitivity of decision making to the framing of
problems.
• Bounded rationality designates rational choice that takes into account
the cognitive limitations of the decision-maker, limitations of both
knowledge and computational capacity. Bounded rationality is a central
theme in the behavioral approach to economics, which is deeply
concerned with the ways in which the actual decision-making process
influences the decisions that are reached.
◼ Modern financial economics relies on the notion of
efficient markets which assumes that individuals act in a
rational way
◼ In particular, the whole field is based on the assumption
that the “representative agent” is rational which does not
imply that all agents are rational
VARIATIONS OF THE EMH

There are three variations of EMH which represent three

different assumed levels of market efficiency:
1. Weak form
2. Semi-strong form
3. Strong form
VARIATIONS OF THE EMH

1. Weak form – assumes that the prices of

securities reflect all available public market
information but may not reflect new
information that is not yet publicly available
Weak Form
- it also assumes that past prices do not
influence future prices, which will instead be
informed by new information
Information
in past stock
prices
- fundamental analysis , not technical analysis
VARIATIONS OF THE EMH

2. Semi-strong form – incorporates the

Semi-strong form
weak form assumptions and expands
on this by assuming that prices
Weak Form adjust quickly to any new public
All public information
information that becomes available
- dismisses the usefulness of both
Information
in past stock technical and fundamental analysis
prices
VARIATIONS OF THE EMH
Strong form 3. Strong form – assumes that prices
always reflect the entirety of both
Semi-strong form
public and private information
Weak Form
- not even insider knowledge can
All available information
give investors a predictive edge
All public information + insider that will enable them to
and
private consistently generate returns that
Information info
in past stock outperform the overall market
prices
average
 KEY THEMES IN BEHAVIORAL FINANCE
• Emotional Influences: Emotions such as fear, greed, and overconfidence can significantly affect
investment choices. Emotional responses can lead to impulsive decisions or market anomalies.
• Loss Aversion: People tend to feel the pain of losses more strongly than the pleasure of gains. This
leads to risk-averse behavior and can result in suboptimal investment decisions.
• Herding Behavior: Individuals often follow the actions of others, even if those actions seem
irrational. This herd mentality can cause market bubbles and crashes as well as mispricing of
assets.
• Overconfidence: Many individuals overestimate their own abilities and information, leading to
excessive trading and a tendency to ignore risks. Overconfidence can result in poor investment
performance.
KEY THEMES IN BEHAVIORAL FINANCE
• Anchoring: People tend to rely heavily on the first piece of information they receive
when making decisions. This can cause them to stick with initial beliefs or reference
points even when new information suggests a change is warranted.
• Mental Accounting: People tend to compartmentalize their money into different
mental accounts, which can lead to irrational behavior. For example, they might
treat windfall gains differently from regular income.
• Framing: The way information is presented (framed) can significantly influence
decisions. People often make different choices based on how a problem or option is
presented, even if the underlying content is the same.
 KEY THEMES IN BEHAVIORAL FINANCE
• Regret Aversion: People avoid making decisions that might lead to regret, often by sticking
with the status quo. This can prevent them from taking necessary risks or making changes in
their investments.
• Disposition Effect: Investors tend to sell assets that have gained in value too early and hold
onto losing assets for too long, a behavior that can be attributed to aversion to regret.
• Prospect Theory: Proposed by Daniel Kahneman and Amos Tversky, this theory suggests that
people evaluate potential outcomes relative to a reference point (usually the status quo) and
that they exhibit risk-seeking behavior for potential losses and risk-averse behavior for
potential gains.
• Limits to Arbitrage: Behavioral biases can prevent arbitrageurs from fully correcting
mispricings, allowing anomalies to persist in the market. This challenges the efficiency of
markets predicted by traditional finance theories.
STANDARD VS BEHAVIORAL