MEANING OF BEHAVIOURAL FINANCE

Behavioural finance is the study of the influence of psychology on the behaviour of financial
practitioners and the subsequent effect on market. According to behavioural finance, investors’
market behaviour derives from psychological principles of decision-making to explain why people
buy or sell stock. Behavioural finance focuses upon how investor interprets and acts on information
to take various investment decisions. In addition, behavioural finance also places emphasis on
investor’s behaviour leading to various market anomalies. Behavioural Finance (BF) is the study of
investors’ psychology while making financial decisions. Investors fall prey to their own and
sometimes others’ mistakes due to use of emotions in financial decision-making. For many financial
advisors BF is still an unfamiliar and unused subject. There are some financial advisors, however,
who have taken the time to read and learn about BF and use it in practice with good results. These
advisors realize that being successful is just as much about building great relationships with clients as
it is about delivering investment performance. And they have observed that BF can provide tools
that can help them ‘get inside’ the head of their clients in order to build mutually beneficial
relationships. Understanding how clients actually think and behave is a key ingredient in the recipe
for success in acquiring and retaining clients. As such, BF is becoming a powerful force in the
financial advisory field. BF tries to understand how people forget fundamentals and take investment
decisions based on emotions. For decades, economists have argued about the rational behaviour of
investorsNow psychologists are weighing in, and they are finding that human beings often do not act
that way. “Psychology has a story to tell about investing, and it is different from the one economics
tells,” says Princeton Psychologist Daniel Kahneman. BF is the study of the influence of psychology
on the behaviour of financial practitioners and the subsequent effect on markets. Research in this
area is emerging from the academia and the results are being taken into account in the field of
money management. Finance practitioners use rules of thumb or heuristics to process data. For
example, people use past performance as the best predictor for future performance and often invest
in the mutual funds with the best five-year track records. These rules are likely to be faulty and
generally lead to poor decisions. Relying on such heuristics is called ‘Heuristic Bias’.

DEVELOPMENT OF BEHAVIORAL FINANCE

The rationality of traditional finance is questionable because traditional finance theories cannot give
a proper explanation for it (Copur, 2015). The traditional finance theories are based on certain
assumptions. These are investors are rational, the market is efficient, investors form their portfolio
based on the mean-variance rule and the expected return are the function of the risk. Behavioural
finance criticized each and every assumption saying that investors are normal or irrational, the
market is not efficient, investors do not construct their portfolio based on mean-variance and risk is
not the function of the expected return. Behavioural finance developed in the 1980s by different
researchers from different fields combining together like economics, sociology, psychology and
engineering (Werner DeBondt et. al.) it is still in its developing stage. It has attracted interdisciplinary
researchers especially from economics, sociology, and psychology and the original researchers are
still now the leading researchers in this filed. Behavioural finance studies the behaviour of investor
and their decision behaviour based on the psychological and sociological factors Psychology to
Finance The credence of the new dimension of Behavioural Finance is being defined as the
application of psychology to finance. The evolution of this proliferated section explains the way of
thinking process of investors counting with the emotional cycle, which actually intervene in the
decision making process. Behavioural finance is being built on the basic tilt of understanding of the
fields like Psychology, Sociology and Finance
NATURE

• Behavioural Finance is just not a part of finance.

• It is something which is much broader and wider and includes the insights from behavioural
economics, psychology and microeconomic theory.

• The main theme of the traditional finance is to avoid all the possible effects of individual’s
personality and mind-set

BRANCHES OF BEHAVIOURAL FINANCE •

Micro Behavioural Finance: – This deals with the behaviour of individual investors. – In this the
irrational investors are compared to rational investors (also known as homo economics or rational
economic man)

Macro Behavioural Finance: – This deals with the drawbacks of efficient market hypothesis. – EMH
is one of the models in conventional finance that helps us understand the trend of financial markets.

BEHAVIOURAL FINANCE AS SCIENCE AS WELL AS AN ART •

Behavioural Finance as a Science: • Science is a systematic and scientific way of observing,

recording, analysing and interpreting any event. • Behavioural Finance has got its inputs from
traditional finance which is a systematic and well-designed subject based on various theories. • On
this basis behavioural finance can be said to be a science. The theories of standard finance also helps
in justifying the price movements and trends of stocks (Fundamental Analysis), the direction of
market (Technical Analysis), construction, revision and evaluation of investors’ portfolios( Markowitz
Model, Sharpe’s Performance Index, Treynor’s Performance Index, various formula and plans of
portfolio revision) •

Behavioural Finance as an Art • In art we create our own rules and not work on rules of thumb as in
science. Art helps us to use theoretical concepts in the practical world. • Behavioural finance
focuses on the reasons that limit the theories of standard finance and also the reasons for market
anomalies created. • It provides various tailor made solutions to the investors to be applied in their
financial planning. • Based on above behavioural finance can be said to be an art of finance in a
more practical manner. It also helps to guide the investors to identify themselves better by providing
various models of human personality.

SCOPE OF BEHAVIOURAL FINANCE • To understand the Reasons of Market Anomalies: though

standard finance theories are able to justify the stock markets to a great extent, still there are many
market anomalies that takes place in the stock market, like creation of bubbles, the effect of any
event, calendar effect on stock market and trade etc. these market anomalies remain unanswered in
standard finance but behavioural finance provides explanations and remedial actions to various
market anomalies. • To Identify Investor’s Personalities: study of behavioural finance helps in
identifying the different type of investors 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 unwanted biases created in financial markets. • Helps to identify the risks and
their hedging strategies: because of various anomalies in the stock market, investments these days
are not only exposed to the identified risks, but also to the uncertainty of the returns. • Provides an
explanation to various corporate activities: behavioural Finance provides explanations on the
behaviour of the investors towards a stock once the dividend has been declared or Effect of good or
bad news, stock split, dividend decision etc. • To enhance the skill set of investment advisors: It can
be done by better understanding of investor’s goal, maintaining a systematic approach to advise,
earn the expected return and maintain win-win situation for both the client and the advisors.

OBJECTIVES OF BEHAVORIAL FINANCE

• Correct decision making • Provide knowledge to unaware investors • Identifies emotions and
mental errors • Delivering what the client expects • Ensuring mutual benefits • Maintaining a
consistent approach • Examining a consistent approach

SIGNIFICANCE OF BEHAVORIAL FINANCE

Determining goals of investors • Defines investors’ biases • Manages behavioural biases • Helps in
investment decisions • Helps for financial advisors’ and fund managers • Signifies that investors are
emotional
ANOMALIES OF FINANCIAL MARKET

‘Anomaly’ in general is nothing but the deviation from what is set as a standard which is being
expected in normal parlances. (Tversky & Kahneman, 1986), defined market anomalies as “an
anomaly is a deviation from the presently accepted paradigms that is too widespread to be ignored,
too systematic to be dismissed as random error, and too fundamental to be accommodated by
relaxing the normative system”. Market inefficiency assumes just a logical and rational behaviour
which actually contradicts with the Efficient Market Hypothesis. The variance in stock price and
returns in financial markets paved the way for the field of ‘Behavioural Finance’.

Fundamental Anomaly Fundamental irregularities in stock performance contradict with the Efficient
Market Hypothesis and states that investors can earn abnormal returns. It folds in its layers in the
form of value anomalies and small-cap effect, low price to book value, high-dividend yield, price to
sales ratio, price to earnings etc.

Calendar Anomaly This anomaly can be seen with reference to a particular time. Some of the
specific periods are weekend effect, turn on the month effect, turn on the year effect, January effect.
The broadened framework also includes the announcements of information regarding stock splits,
dividend, results, earnings and mergers & acquisitions

Technical Anomaly Technical analysis encompasses that security’s prices can be forecasted by
studying the past prices. This analysis sometimes reveals the irregularity with EMH, thus anomalies
in this arena arise. The most common techniques include moving averages, relative strength,
support and resistance. It is being a debatable topic because weak form of EMH asserts that prices
adjust rapidly with the flow of information that is why there is no use of technical analysis however,
opponents argue that technical strategies exists These anomalies dig that markets are neither
efficient nor anomalous and this actually violates modern financial and economic
. The formation of behavioural finance finds its roots from here, which is the convention of
psychology to finance. The irrational behaviour of investor gives birth to the notion of biases which
depicts how an investor reacts in certain circumstances.