 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.
For many financial advisors Behavioural finance 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.
E.g. John own share of XYZ Inc & wants to hold on to then despite the company’s declining
performance. He only read articles & analysts reports that confirm his belief that company will
turnaround, ignoring negative news.
 CHARACTERISTICS OF BEHAVIOURAL FINANCE
Four Key Themes- Heuristics, Framing, Emotions and Market Impact characterized the Field.
These themes are integrated into review and application of investments, corporations, markets,
regulations, and educations-research.
1. HEURISTICS: 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
that simplify the complex methods to make a judgment. Investor as decision maker
confronts a set of choices within certainty and limited ability to quantify results. This
leads
identification and understanding of all heuristics that affect financial decision making.
Some of heuristics are representativeness, anchoring & adjustments, familiarity,
overconfidence, regret aversion, conservatism, mental accounting, availability, ambiguity
aversion and effect. Heuristics help to make decision.

2. 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. Psychologists refer this behaviour as a’ frame
dependence’.
3. EMOTIONS: Emotions and associated human unconscious needs, fantasies, and fears
drive much decision of human beings.
4. MARKET IMPACT: Do the Cognitive errors and biases of individuals and groups of
people affect market and market prices? 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 explained by psychology? Standard finance
argues that investors’ mistakes would not affect market prices because when prices
deviate from fundamental value, rational investor would exploit the mispricing for their
own profit. But who are those who keep the market efficient? Even institutional investor
exhibits the inefficiency. And other limit to this is arbitrage. This prevents rational
 investor from correcting price deviations from fundamental value. This leaves open the
possibility that correlated cognitive errors of investor could affect market prices.

 NATURE OF BEHAVIOURAL FINANCE

• 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 micro economic 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

1. Micro Behavioural Finance: examines individual investor behaviour & decision

making. In this the irrational investor are compared to rational investors (also known as
homo economies or rational economic man)
Includes:
 Cognitive Biases (e.g. Confirmation bias, anchoring)
 Emotional influence (e.g. fear, greed)
 Heuristics (e.g. mental shortcuts)
 Prospect theory (loss aversion)
 Investor personality traits (e.g. Risk tolerance)
 Decision making under uncertainity

E.g. Consider an investor who avoids investing in particular stock because they remember a
past loss, even when the stocks fundamentals suggest it is a good opportunity. This
emotional response includes or driven by loss aversion.

2. Macro Behavioural Finance: examines market wide phenomena & aggregate investor
behaviour. EMH is one of model in conventional finance that helps us understand the
trend of financial markets.
Includes:
 Market sentiments & mood
 Social influence & holding
 Market bubbles & crashes
 Aggregate risk premium
 Market efficiency & anomalies
E.g. During market downturn widespread panic can lead to herd behaviour where investor
sell off assets encase, causing prices to plummet further. Thus, collective anxiety can create
a feedback loop, worsening the downturn & effecting overall economic stability.
 BEHAVIOURAL FINANCE AS SCIENCE AS WELL AS AN ART
 Behavioural Finance as a Science:
 Science is a systematic and scientific way of observing, recording, analyzing 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 help 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.

 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 advice, earn the expected return and
maintain win-win situation for both the client and the advisors.

 SIGNIFICANCE OF BEHAVORIAL FINANCE

1. Determining goals of investors: understanding goals of investors is vital in

behavioural finance as it reveals how psychological factors shape their decision
making. Investors may have varied motivations such as wealth accumulation,
retirement planning or funding education that influence their risk tolerance
&behaviour.
E.g. A short-term investor may engage in speculative trading for quick gains while
long term investors might prioritize stability.

2. Define Investor Biases: It means that investor biases lead to systematic errors in
judgement that affect decision making, stemming from psychological factors. In
behavioural finance these biases such as overconfidence, loss aversion & herd
behaviour can lead to irrational investment choices & market inefficiencies.
Understanding these biases is significant is significant because it helps investors &
advisors recognize & mitigate their impact leading to more informed decisions.

3. Managing Behavioural biases: It is a key aspect of Behaviour finance as it helps

investors recognize & counteract the cognitive distortion that can lead to poor
decision making. By understanding biases like overconfidence or loss aversion,
investors can develop strategies to mitigate their effects such as setting clear
investment goals or using checklist to guide choices
4. Helps in investment decisions: Behavioural Finance significantly aids investment
decisions by highlighting the psychological factors that influence investors
behaviour. By understand biases such as anchoring, herd mentality and
overconfidence investors can make informed choices and avoid common pitfalls.

5. Helps for financial advisors and fund managers: Behaviour finance is essential for
financial advisor and fund managers as it provides insights into investors psychology
and behaviour. By understanding biases that affect client decisions such as loss
aversion and herd behaviour advisors can tailor their communication and strategies to
better align with client need and emotions.

6. Signifies that investors are emotional: Behaviour finance underscores that

investors are often driven by emotions which significantly impact their financial
decisions.
 Emotional factors like fear and greed can lead to irrational behaviour such as panic
selling during market downturns or excessive risk-taking during bull market.

 INVESTMENT DECISION CYCLE

Behavioral finance explores how psychological factors influence investment

decisions, revealing that cognitive errors &biases are systematic & often predictable
through primarily observable after fact. While it’s easier to explain past financial
decisions predicting future behaviour in similar situations remain challenging.
Investors frequently make irrational choices due to emotional influences &human
nature which can over ride education &analytical skills. Despite sophisticated
financial data the human element in decision making introduce vulnerabilities.
This predictability of biases suggests that rational investors can potentially
capitalize on non-rational actions of others in market.

In Fig - above shows an approximation of the emotional states that accompany a typical market
cycle. The dashed line are representation of asset prices through an economic expansion and
ensuing recession.
Reluctance
It is worth starting with the word that occurs at both the start and end of the chart: reluctance.
This is the default state of most investors. In normal circumstances we fear taking a risk and
getting it wrong, more than we fear missing out. This reluctance to get involved is compounded
by another strong behavioural effect: loss aversion.
Optimism to Exuberance
Reluctance starts diminishing when markets pick up and the economy enters a positive phase.
Fear of loss quickly turns into a fear of missing out. Our natural aversion to loss may now cause
us to take action to increase short-term emotional comfort, this time by entering the market.
Denial to panic
 Investors always try to compute gains and losses from the point at which they enter the market.
Only those investors who are in immediate need of liquidity try to sell the holdings, but
remaining investors hesitate to sell the stocks in loss (i.e. prefer to hold loss making securities).
But further fall in the market price leads them to panic situation. Few of the investors may be
found to sell their investments for reasons other than liquidity needs. Thus, we see fall in price a
common phenomenon in all these points, only difference is volume. Volume which is dried up at
denial stages bursts at panic stage.
Capitulation to reluctance
On the way down, loss aversion and denial tend to cause investors to hold on to their
investments. As their portfolio plummets, the emotional pain of selling at a loss increases too, but
at a diminishing rate. Losing 5% hurts, but the first 5% hurts the most. Once you‘ve already lost
30%, the difference between -35% and -30% feels less significant than the difference between -
5% and no loss at all. The point of despondence can be explained as a point of maximum safety.
Hence buying process starts due to emotional safety assumed by investors. When volume of
buying gradually increases, there will be phases like depression, apathy and indifference.

 JUDGMENT UNDER UNCERTAINTY

Heuristics are shortcuts and rule of thumb approaches used by human mind while making a
decision on variable which are highly uncertain. Such use of heuristics can cause bias and lead to
irrational responses from investors. In 1974, two brilliant psychologists, Amos Tversky and
Daniel Kahneman described three heuristics that are employed when making judgments under
uncertainty.
Representativeness Heuristics: When people are asked to judge the probability that an object or
event A belongs to class or process B, probabilities are evaluated by the degree to which A is
representative of B, that is, by the degree to which A resembles B.
Availability Heuristics: When people are asked to assess the frequency of a class or the
probability of an event, they do so by the ease with which instances or occurrences can be
brought to mind.
Anchoring and adjustment Heuristics: In numerical prediction, when a relevant value (an
anchor) is available, people make estimates by starting from an initial value (the anchor) that is
adjusted to yield the _nal answer. The anchor may be suggested by the formulation of the
problem, or it may be the result of a partial computation. In either case, adjustments are typically
insufficient.
 BEHAVIOURAL BIASES THAT INFLUENCE INVESTMENT DECISIONS
a. Denial: Most of the times investors do not want to believe that the stock they have held
since ages has become under-performing or they need to sell it off. They are in a constant
state of denial. Even through the said asset brings the overall return of the portfolio down,
investors are reluctant to part with it.
b. Information processing errors: Often referred to as the heuristic simplification,
information-processing error is one of the biases of investor psychology. These people
use the simplest approach to solve a problem rather than depending on logical reasoning.
Heuristic simplification can be detrimental to the investing decisions. This is done by
omitting crucial information to reduce complexity and processing only part information.
Such an approach can lead to flawed decisions which can be dangerous to the stock
market.
c. Emotions: Most of the behavioural anomalies stem from extreme emotions of the
investors. This happens when investors do not make decisions with an objective mind and
only tend to respond to their biases. Misconceptions, misinterpretations, risk-aversion,
past experiences all combine to block the logical bent of mind and exposes the
investment decisions to possibilities of risk and losses.

d. Loss Aversion: The risk-taking ability of each investor is different. Some are
conservative in their approach while others believe in taking calculated risks.
However, among the conservative investors are few who fear losses like anything.
They may be
aware about the potential gains from an asset class but are intimidated by the prospects of
incurring even a short-term loss. In short, their excitement for gains is much less than
their aversion towards losses. Needless to say these investors miss out on quite a few
fruitful investments.

e. Social influence/herd mentality: Herding is quite an infamous phenomenon in the stock

markets and is the result of massive sell offs and rallies. These investors do not put in
deep research behind their decisions and only follow the sentiment of the crowd whether
positive or negative. Whether it was the tech-bubble in the early 90s, the subprime crisis
in 2008, the Eurozone crisis in 2010 or the recent banking sector scams in India, the
market has seen huge sell-offs. Most of them weren't even warranted.

f. Framing: According to the Modern Portfolio Theory, an investment cannot be

evaluated in isolation. It has to be viewed in the light of the entire portfolio. Instead of
focusing on individual securities, investors should have a broader vision of wealth
management.
However, there are investors who single out assets or a particular investment for
evaluation. This is viewing at things through a "narrow frame". This may lead to
losses. Investors need to look at the holistic picture and evaluate with a "wider frame”.

g. Anchoring: Many a time investors hold on to a particular belief and refuse to part ways
with it. They "anchor" their beliefs to that notions and have difficulty in accepting any
new piece of information related to the subject. This is true in cases wherein a real estate
or pharmaceutical company is involved in a legal battle or bank has been involved in a
scam. This negative information is received with greater intensity, so much so that no
other piece of positive information can neutralize its effect.
 APPROACHES TO DECISION-MAKING IN BEHAVIOURAL 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.

 MENTAL ACCOUNTING
It is the process by which people organize, evaluate and keep track of their financial
activities (Thaler, 1999). This happens when people segregate their money into separate
accounts based on some subjective criteria.
Mental accounting is a habit which is frequently practiced by many individuals on a daily
basis. Thus, mental accounting is considered to be irrational. Tversky and Kahneman (1981)
throw more light on this bias with the help of following illustration.

Situation 1: Imagine that you have decided to see a play where admission is Rs.10 per ticket.
As you enter the theatre, you discover that you have lost a Rs.10 bill. Would you still pay
Rs.10 for a ticket for the play? Answer yes or no.
Situation 2: Imagine that you have decided to see a play and paid the admission price of
Rs.10 per ticket. As you enter the theatre, you discover that you have lost the ticket. The seat
was not marked and the ticket cannot be recovered. Would you pay Rs.10 for another ticket?
Answer yes or no.
It is clear that in both the situations Rs.10 is lost and cannot be recovered. The only
difference is that, in the first situation, it is lost in the form of cash and in the second it
happened in the form of a ticket. However, the results of the survey were strikingly different.
It was observed that in Situation 1, 88 per cent people said yes for buying another ticket
while in Situation 2, the majority said no (54%). Tversky and Kahneman (1981) call this a
psychological accounting that is happening in respondents' minds.

Opening and Closing Accounts

The difference in the responses is due to mental accounting. Mental accounting is one
method people use to make decision-making manageable.

Example of mental accounting

1. Tax Refunds
A tax refund is a reimbursement of the excess amount of tax paid by a taxpayer to the
federal or state government. If a taxpayer receives a refund, it means they overpaid their
taxes in the previous tax year, and this represents an interest-free loan to the government.
2. Bonuses
A bonus is a payment to a person above and beyond their regular income
Usually, bonuses are awarded as a form of incentive to entry-level and senior-level
employees.
 As a result, many employees spend their bonuses on unnecessary expenses such as cars,
vacations, fancy clothing, etc.
3. Mental Accounting in Investing
Mental accounting also exists in investing, as investors choose the assets to invest in
speculative and safe portfolios.
Money that you can afford to lose is a mental accounting bias, since all money is the same,
and there is no decision that would justify losing any money you own.

 HYPERBOLIC DISCOUNTING

 It states that most people discount larger rewards to be received in future in favour
of smaller or sooner to be received at present.
 Hyperbolic discounting is a particular form of temporal discounting. Temporal
discounting measures differences in relative valuation place on rewards (usually money
or goods) at different points in time by comparing it valuation at an earlier date with one
for a later date.
 Immediate gratification of rewards is a human tendency and it is termed as hyperbolic
discounting.
 For e.g. If an individual is given a choice to receive Rs.1000 in two weeks & Rs. 2000 in
six weeks he will engage in time discounting & choose the soon to be received reward.
 Samuel McClure, a neuroscientist from Princeton University, conducted an experiment
with his colleagues where he gave several decision pairs to them and asked to assert
their preferences. He finds that nearly all the subjects engaged in time discounting.

 Why Hyperbolic discounting happens?

 People or Investors are risk averse.

 Investors are aware that their preferences might change
 Investors have a urgent need.

 How can Investor avoid Hyperbolic discounting?

 Consider the immediacy of benefits of decisions or products or the sacrifices you are
offering.
 Pre commitment of a goal to achieve positive change .
 Breakdown goals into manageable chunks.

 COGNITIVE INFORMATION PERCEPTION

 Cognitive psychology is the scientific study of the mind as an information processor. Cognitive
psychologists try to build up cognitive models of the information processing that goes on
inside people‘s minds, including perception, attention, language, memory, thinking, and
consciousness.
 Cognitive perception includes, aside from the senses listening, seeing, smelling, tasting and
feeling, the way in which we deal with information. While perception refers to ways of obtaining
 information from our environment, cognition describes processes such as remembering,
learning, solving problems and orientation.
 People use heuristics to control extreme complexity. Heuristics are strategies for information
processing, which help to find a quick but not necessarily optimal decision. Standard finance
assumes unlimited cerebral capacity, but in reality human cognitive system likes to process
only a limited information. In behavioural finance it is believed that people tends to make
decisions with inadequate and imperfect information and have limited cognitive capacity. Thus
relying on heuristics is a common process in business decision making under risk and
uncertainty. A heuristic is a crude rule of thumb for making judgments about probabilities,
future outcomes, and so on. A bias is a tendency toward making judgmental errors. The
heuristic and biases approach studies different kinds of short cuts people employ to form
judgments and the associated biases in those judgments.
System 1:
 It operates automatically &rapidly.
 It requires little or no efforts
 Heuristics are used in processing the information.
System 2:
 It is effortful, deliberate& slow.
 It requires mental abilities(activities) and includes complex calculations.
 It is lazy and works slowly.
 For understanding of cognitive information perception, understanding of working of these
two systems of human brain is important. Psychologists Keith Stanovich and Richard West
refer to them as System 1 and System 2. System 1 operates automatically and rapidly. It requires
little or no effort and is not amenable to voluntary control. System 2 is effortful, deliberate and
slow. It requires mental activities that may be demanding, including complex calculations. As
Daniel Kahneman put it, ― “The operations of system 2 are often associated with the subjective
experience of agency, choice and concentration.”

 PECULIARITIES OF QUANTITATIVE AND NUMERICAL INFORMATION PERCEPTION

 People including the investment community had their own problems in understanding the
computations in mathematics. This is especially true in their capability to deal with
probability concept. Bias in terms of quantitative and numerical information perception is an
unavoidable fact.
Innumeracy: In his book Innumeracy: Mathematical Illiteracy and its consequences, John
Paulos noted that ― some of the blocks to dealing comfortably with numbers and probabilities
are due to quite natural psychological responses to uncertainty to coincidence, or to how a
problem is framed. Trouble with numbers is reflected in the following areas.
1. Money illusion: People have a continued trouble in understanding the monetary values because,
they seldom understands the meaning of nominal value and real value. The impact of inflation
is a very hard econometrics that can be easily interpreted by people in framing the decisions on
investment. They tends to make illogical approximations or just satisfies with time value of
money ( capital budgeting) which is more convenient way to understand the profitability of
investment.

2. True probabilities: People due to their familiarity or otherwise tends to overestimate the
probability or underestimate it even though numerically they have equal chances of occurrence.
3. Big numbers and small numbers: Another irrational attitude is identified in choosing between
numbers is the tendency of choosing the bigger number and ignoring smaller numbers. For
example, in taking capital budgeting decisions, generally higher number NPV are compared
for making the choice and Profitability index which is mostly a two digit number is ignored. In
the study of financial statements, only the total net earnings are observed by EPS is ignored.

4. Base rate v/s case rate : To understand the fundamental strength of an entity at the time
of investment, base rate cannot be ignored. But the limited cerebral capabilities in processing
vast information for the purpose of understanding the base rate automatically avoids such
cumbersome calculations and searches for a shortcut route of considering the case rate as a
substitute for it. Case rate means processing currently available small amount of information.