Behavioral Finance

Books

1.Behavioral Finance: Psychology, Decision-Making, and Markets,

Cengage Learning. Ackert, L., & R. Deaves. (2010)

2. Behavioral Corporate Finance, 1st edition Shefrin, H. (2007) Pearson

3. The Psychology of Investing, 5th edition (international edition)

Nofsinger, J. (2014) Mc Graw Hill

4. Behavioral Finance Prasanna Chandra Mc Graw Hill

An Overview of Behavioral Finance
What is behavioral Finance?

Behavioral finance is a field of study that combines

psychological theories with conventional economic and
financial theories to understand the impact of cognitive
biases and emotions on financial decision-making.

This interdisciplinary approach helps explain why people

often make irrational financial choices, deviating from the
assumptions of traditional finance models.
Traditional Financial Theory says….
 Both the market and investors are perfectly rational.

 Investors truly care about utilitarian characteristics.

 Investors have perfect self-control.

 They are not confused by cognitive errors or information

processing errors.
Behavioral finance says….
 Investors are treated as “normal” not “rational”.

 They actually have limits to their self-control.

 Investors are influenced by their own biases.

 Investors make cognitive errors that can lead to wrong

decisions.
 Brief History of Behavioral Finance

 The concept of behavioral finance dates to 1912 when George Seldon

published “Psychology of the Stock Market.” However, the theory gained
popularity and momentum in 1979 when Daniel Kahneman and Amos
Tversky proposed that most investors tend to make decisions based on
subjective reference points rather than objectively choosing the best
option.
 A year later, Richard Thaler introduced the notion of “mental accounting,”
which is the idea that people view their money differently based on its
function, such as whether it’s for retirement or education. Eventually,
their work became the basis for the study of cognitive psychology and
behavioral biases in finance, which features prominently in the field of
behavioral finance.
 Understanding behavioral finance is crucial for investors, financial
professionals and policymakers as it provides valuable insights into the
psychological factors influencing financial decisions.

Investment managers can use behavioral finance concepts to understand

better how investors make decisions and to develop investment
strategies that account for behavioral biases.
 By identifying and addressing these biases, individuals, and organizations
can make better-informed decisions, ultimately improving financial
outcomes and market efficiency.

 For example, they can use prospect theory to design investment

portfolios that minimize the impact of loss aversion
Bounded Rationality

Bounded rationality is the idea that individuals have

limited cognitive resources, time, and information to
make optimal decisions. As a result, people often
rely on heuristics or mental shortcuts to simplify
complex decision-making processes.
Heuristics
 Heuristics are mental shortcuts that individuals use to make quick and
efficient decisions. While heuristics can be helpful, they can also lead to
systematic errors or biases in judgment.
 Heuristics is the process of simplifying a problem when you don’t have
enough information to make a “perfect” decision.
 In these instances, you’re likely to use a shortcut or rule-of-thumb to
make a decision that feels right. Heuristics simplify the decision-making
process, which means they simplify the financial decision making
process, as well. Without them, you'd have to spend much more time
making decisions. However, relying on heuristics without carefully
analyzing investment options can lead to irrational or incorrect
decisions.
Prospect Theory
Daniel Kahneman and Amos Tversky developed prospect theory
as a cornerstone of behavioral finance.
It posits that people evaluate financial outcomes based on gains
and losses relative to a reference point rather than final wealth
levels. Individuals are also more sensitive to losses than gains,
exhibiting loss aversion.
Loss Aversion
 Loss aversion is the tendency for individuals to prefer avoiding losses
over acquiring equivalent gains. This bias can lead to risk-averse
behavior when facing potential gains and risk-seeking behavior when
facing potential losses.
 People feel the pain of a loss more acutely than the euphoria of a win,
even if they win more than they lose.
 In financial terms, investors will often hold onto stocks they should sell
to avoid realizing a loss. Conversely, they may sell too early to avoid
further losses, when waiting for a market rebound would be the better
option. Often investors with a strong loss aversion bias have portfolios
that are too conservative, underperforming market norms.
Mental Accounting
Mental accounting, introduced by Richard Thaler, refers to the
tendency of individuals to categorize and evaluate financial
transactions in separate mental accounts, which can influence their
financial choices and risk-taking behavior.
In mental accounting, you place different values on money based on
how you obtained it. If you buy a winning lottery ticket, for instance,
you might blow it all on a spontaneous shopping spree even though
you carefully budget your salary. This can lead to irrational financial
decisions.
Overconfidence
Overconfidence is a cognitive bias that causes people to overestimate their
knowledge, skills, or ability to predict future outcomes. In finance,
overconfidence can lead to excessive trading, under-diversification, and
inadequate risk management.

Most people tend to overestimate their abilities in many areas. When you
overestimate how much you know about the market or a specific stock,
you’ll be tempted to make risky decisions like trying to time the market,
which is trying to predict the best time to buy or sell stocks, or
overinvesting in high-risk stocks, which are more likely to lose money.
Confirmation Bias
 Confirmation bias is the tendency to seek, interpret, and remember
information that confirms one's pre-existing beliefs while ignoring or
discounting contradictory evidence.
 This bias can contribute to investment mistakes, such as holding onto losing
positions or overlooking red flags.
 Confirmation bias explains how two people with opposing viewpoints can
hear the same information, and each comes away believing it supports
their opinion. When you have a firmly-held belief, you give heavier weight
to evidence supporting your belief while minimizing evidence contradicting
it.
 In finance, confirmation bias can lead you to overlook investment strategies
or assets that fall outside of your bubble, causing you to miss significant
growth opportunities. You may also invest too heavily in one area because
you haven’t fully analyzed the risks.
Anchoring
Anchoring refers to the tendency of individuals to rely heavily on the first
piece of information they encounter when making decisions. In financial
contexts, anchoring can lead to irrational pricing and investment decisions
based on arbitrary reference points.
Anchoring is a type of heuristics that involves subconsciously using irrelevant
information as a reference point. Historical values are common anchors. For
example, if you bought a stock for Rs. 100 but it starts losing its value, you
may be tempted to hold onto it because you don’t want to sell it for less.
Salespeople take advantage of anchoring by starting negotiations at far above
market value. The inflated price serves as an anchor, so when they come
down, it’ll seem like a good deal.
Herding Behavior /Herd Mentality
 Herding behavior is individuals' tendency to follow a larger group's actions
or beliefs, even if it contradicts their own judgment or available
information. In finance, herding can contribute to market bubbles and
crashes.
 Humans are social animals, so going along with the crowd is in our nature.
From the hot new fashion trend everyone is wearing to the crowded
restaurant that requires you to make reservations months in advance,
people tend to make choices based on what others are doing.

 In financial markets, herd mentality can lead to asset bubbles, which is

when the price of an asset like a stock rises rapidly but will eventually fall,
and market crashes, which occur when a lot of investors sell off their stock.
Availability Bias
Availability bias is the tendency to rely on readily
available information or recent experiences when
making decisions, often leading to a distorted
perception of probabilities and risks.
 Applications of Behavioral Finance

 Personal Finance and Investing

Behavioral finance can help individuals recognize and address their own
cognitive biases and emotional tendencies, leading to better financial
decision-making and improved investment outcomes.

 Corporate Finance

In corporate finance, understanding behavioral biases can help managers

make more informed decisions regarding capital allocation, risk
management, and mergers and acquisitions.
 Portfolio Management
Portfolio managers can apply behavioral finance principles
to construct diversified portfolios, taking into account investors' risk
tolerance, loss aversion, and other behavioral factors.

 Retirement Planning
Behavioral finance can inform retirement planning by helping
individuals recognize and overcome biases that may hinder their
ability to save adequately, invest wisely, and make appropriate
decisions regarding pensions and annuities.
 Risk Management
Incorporating behavioral finance into risk management can help
organizations and individuals identify and address biases that may lead
to excessive risk-taking or underestimating potential risks.
 Market Efficiency and Pricing
Understanding the impact of behavioral biases on market efficiency and
asset pricing can help investors, financial professionals, and policymakers
develop strategies to mitigate market inefficiencies and improve overall
market stability
 Behavioral Economics and Public Policy
Behavioral finance insights can be applied to public policy initiatives,
such as designing pension systems, promoting financial literacy, or
implementing regulations that protect investors from the consequences
of irrational decision-making.
 Limitations of Behavioral Finance
 Overemphasis on Biases and Irrationality
Critics argue that behavioral finance may overstate the
prevalence and impact of cognitive biases and emotional
influences, leading to an overly negative view of human
decision-making abilities.

 Difficulty in Quantifying Behavioral Factors

Quantifying the effects of behavioral biases on financial
decision-making and market outcomes can be challenging,
making it difficult to develop precise models or to measure the
effectiveness of interventions designed to address these biases.
 Potential for Misuse
The insights of behavioral finance could be misused
by financial professionals or organizations seeking to exploit
individuals' cognitive biases and emotional tendencies for
their own benefit.

 Challenges in Integrating Behavioral Finance With

Traditional Finance
Integrating behavioral finance insights with traditional
finance models and practices can be complex, as it
requires reevaluating long-held assumptions and
developing new tools and frameworks.