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Behavioural Finance
• Th~ Central assumption of
the traditional finance model
rational and stock and bond is that the people are
markets are efficient
• Psychologists have found
that economic decisions are m
manner, so they challenge th ade in an irrational
is assumption of standard fin
• Stock market bubbles and ance
anomalies questioned the effic
iency of stock market
• Behavioural finance was co
nsid
and economist Vernon Smith ered first by the psychologist Daniel Kahneman
, who were awarded the Nobel
2002 Prize in Economics in
• Financial economist starte
d believing that the investor behaves irrati
onally
 Be havioural Finance

• Behavioural finance is a concept developed with the inputs taken from the field of
psychology and finance

Psychology Sociology

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Fmance
 Behavioural Finance

Sewell has defined Behavioural finance as "the study of the influence of

psychology on the behaviour of financial practitioners and the subsequent
effect on markets".

• Behavioural finance is the integration of classical economics and finance with

> psychology and the decision-making sciences. <

• Behavioural finance is an attempt to explain what causes some of the anomalies

that have been observed and reported in the finance literature.
• Behavioural finance is the study of how investors systematically make errors in
judgment or 'mental mistakes.
 NATURE OF BEHAVIOURAL FINANCE
1. Micro Behavioural Finance

This branch deals with the behaviour of individual investors

compare irrational investors to rational investors, as observed in the

rational/classical economic theory. These rational investors are also known as
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"homo economicus" or the rational econo1nic man.

2. Macro Behavioural Finance

deals with the drawbacks of the efficient market hypothesis

Macro behavioural finance also addresses the limitations of Portfolio Principles of

Markowitz, the Capital Asset Pricing Model (CAPM) etc ...
 SCOPE OF BEHAVJOURAL FINANCE
l. To understa nd th e reasons of m arket a n omalies

Including creation of bubbles, the e ffect o f any event, ca le ndar e ffect on s tock m a rke t tra de like Janua ry effect

holiday e ffect

2. To id en tify inves tor 's pe r sonality

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> 3. T o study the r easo n fo1· inational b e hav io ural o f invest ors :

4. To e nha nce the skill set of investment adv isor s

5. H elps to ide nti fy the ris ks a nd d evelop h ed g ing s trategies

6. p1·ovides expla natio n to various corporate a c tiv ities

 -

O BJ EC TI VE S OF BE R AVIOUR
AL FINANCE
I. To rev iew the debatable issues in
standard finance and to protect the inte
sta keh old ers in volatile investment rests of
scenario.
2. To exa mi ne the relationship betwe
en theories of standard finance and Beh
avioural
fin anc e

> 3. To ana lys e the inf lue nce of biases

on the investment process because of <
different
per son alit ies pla yin g in the inv est me
nt market.
4. To dev elo p stra teg ies to mit iga te
behavioural biases
5. To exa mi ne the var iou s social res
ponsibilities of the subject.
6. To dis cus s em erg ing iss ues in the
financial world.
 OBJECTIVES OF BERAVIOURAL FINANCE
7. To discuss the development of new financial instruments.

8. To familiarize themselves with trend of changes over the years across vanous
economies.

9. To examine the contagion effect of various events.

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10. An effort towards more elaborated identification of invcstor·s personality.

11. More elaborate discussions on optimum asset allocation according to age, sex,
income and unique personality of investors
 APPROACH ES TO DECISION-MAKING IN BERAVIOURAL FINANCE
Behavioural finance advocates two approaches to decision-making:

• Reflexive - Following your gut feeling and inherent beliefs. In fact, this is your
default option.

• Reflective - This approach is logical and methodical, something that requires a deep
> thought process. <

The more investors rely on reflexive decision-making, the more exposed they are to
behavioural biases like self-deception biases, heuristic simplification, excess emotions
and herding
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Assumes that people process data appropriately People employ imperfec t rules of thumb
and correctly (heuristics) to process data which induces biases
in their belief and predisposes them to commit
errors.

People view all decision through the transparent Behavioural finance postulates that perceptions
and objective lens of risk and return of risk and return are significantly influenced by
how decision problem is framed. In other
words, behavioural finance assumes frame
> dependence

Assumes that people are guided by reasons and Recognises that emotions and herd instincts
logic and independent judgment . play an importan t role in influencing decisions.
Argues that markets are efficient, implying that Behavioural biases, emotiona l biases social
the price of each security is an unbiased influence often lead to discrepancy between
estimate of its intrinsic value market price and fundamental value
Views that price follow random walk, though Views that prices are pushed by investors to
prices fluctuate to extremes, they are brought unsustainable levels in both directions.
back to equilibriu m in time. (and cannot be (follows pattern and can be predicted using past
 Foundations of Rational Finance

• Expected utility theory

• Modem portfolio theory

• Capital asset pricing model (CAPM)

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• Efficient markets hypothesis
• Agency theory and the influence of psychology