Chapter 1: What Is Behavioral Finance?

Behavioral Finance and Wealth Management

Michael M. Pompian

By
Tamer Azouz Ahmed

Supervised By
Dr. Ahmed Roshdy

At
ESLSCA Business School

October 2024
 Key Figures in Behavioral Finance
Robert Shiller (Yale University) Andrei Shleifer (Harvard University)
- Wrote "Irrational Exuberance“ - Published "Inefficient Markets: An
- Warned of overvalued stock prices Introduction to Behavioral Finance“
before the 2000 market peak - Focused on the efficient market debate
- Predicted potential market
disappointment

Richard Thaler (University of Chicago) Meir Statman (Santa Clara University)

- - Wrote "Behavioral Finance: Past Battles
Co-authored "Can the Market
Add and Subtract?" and Future Engagements“
- - Researched cognitive errors, emotions,
Demonstrated irrational pricing
in 3Com's Palm spin-off and investor aspirations
- - Won multiple awards for his work in
Editor of "Advances in
Behavioral Finance" behavioral finance

Hersh Shefrin (Santa Clara University) Daniel Kahneman & Vernon Smith
- Authored "Beyond Greed and Fear“ - Shared the 2002 Nobel Prize in Economic Sciences
- Argued investors weigh positive past events - Kahneman: Integrated psychological insights into
too heavily economic science
- Predicted the 2000 market meltdown - Smith: Established laboratory experiments in empirical
economic analysis
 What Is Behavioral Finance?
People in standard finance are rational. People in Behavioral Finance are normal

Rational Economic Man

Behavioral Finance A D versus Behaviorally
Micro vs. Behavioral
Biased Man
Finance Macro

The 2 Great debates of

standard finance vs. B
behavioral finance

What is behavioral finance?

The Role of Behavioral

Efficient Markets C E finance with private
versus Irrational clients
Markets

Market anomalies
3 Main types
 Behavioral Finance Micro vs. Behavioral Finance Macro

Behavioral Finance Macro (BFMA)

Behavioral Finance Micro ”BFMI”
- Detects and describe anomalies
- examines behaviors or biases in the efficient market hypothesis
of individual investors - Studies market-level outcomes
- Focuses on how individuals that contradict standard finance
deviate from rational theory
economic actors - Examines how behavioral effects impact overall
- Aims to identify psychological market efficiency
biases influencing investment
decisions
 The 2 Great debates of standard finance vs. behavioral finance

Rational Market and Rational Economic man

01 02 03 04 05

October 18, 2004, The option-pricing theory The standard finance Homo Economicus Standard finance grounds its
Wall Street Journal Standard finance theory is designed to provide approach relies on a set of assumptions in idealized financial
mathematically elegant explanations for financial assumptions that humans make perfectly rational behavior; behavioral finance grounds
stock prices could become questions that, when posed in real life, are often economic decisions at all times
oversimplify reality its assumptions in observed financial
irrational complicated by imprecise, inelegant conditions.
 Efficient Markets versus Irrational Markets
Three forms of the efficient market hypothesis

The Weak form

all past market prices and data are fully
1 reflected in securities prices
technical analysis is of little or no value

2 The Semistrong form

that all publicly available information n is
fully reflected in securities prices

B
fundamental analysis is of no value

3
The Strong form
contends that all information is fully
reflected in securities prices
insider information is of no value

In sum, at any given time in an efficient market, the price of a security will match that
security’s intrinsic value
 Market Anomalies

1
01 Fundamental Anomalies
- Stocks with low price to book value (P/B)
- Low price to earrings (P/E)
- Stocks with high Dividend yields tend to
outperform others

Market Anomalies

2 -
Technical Anomalies
Past securities prices can be used to
predict future securities prices
- Common technical analysis strategies are
based on relative strength and moving
average

3
03 -

-
Calendar Anomalies
The January effect “Abnormally high returns, especially for
small stocks”
last and on the first four days of each month “Higher returns at
month-end and start”
The December effect “Related to mutual fund reporting and
anticipation of January increases”
 Rational Economic Man versus Behaviorally Biased Man

Homo economicus
is a simple model of human economic behavior, which assumes that principles of
perfect self-interest, perfect rationality, and perfect information govern economic decisions by individuals
in a semistrong form; this version does not see rational economic behavior as perfectly predominant
but still assumes an abnormally high occurrence of rational economic traits
Other economists support a weak form of Homo economicus, in which the corresponding traits exist but are not strong

Economists like to use the concept of rational economic man

(1) Homo economicus makes economic analysis relatively simple
(2) Homo economicus allows economists to quantify their findings

Most criticisms of Homo economicus

1. Perfect Rationality. When humans are rational, they have the ability to reason and to make beneficial judgments. However,
rationality is not the sole driver of human behavior (fear, love, hate, pleasure, and pain).
2. Perfect Self-Interest. Many studies have shown that people are not perfectly self-interested
3. Perfect Information. Some people may possess perfect or near-perfect information on certain subjects (It is impossible,
however, for every person to enjoy perfect knowledge of every subject)
 The Role of Behavioral finance with private clients
behavioral finance is increasingly adopted by practitioners, clients will begin to
see the benefits
The key result of behavioral finance: enhanced relationship will be a portfolio to which the advisor
can comfortably adhere while fulfilling the client’s long-term goals
Delivering What the Client Expects
Formulating Financial Goals
- Better understand client
- Understand the psychology and motivations and needs
emotions behind goal-setting - Address the root of client expectations
- Deepen the bond between advisor and more effectively
client

A C

Maintaining a Consistent Approach Ensuring Mutual Benefits

- Incorporate behavioral finance - Improve client satisfaction and
into existing advisory disciplines B D retention
- Add professionalism and - Enhance the advisor's practice and work
structure to the client life
relationship
 Finally
This
understanding
leads to more
appropriate
portfolio

02
design,
stronger client-
advisor bonds, By incorporating
Behavioral and behavioral finance
finance ultimately more insights, advisors can
provides a successful address the primary
framework for advisory reason clients leave

01 advisors to
deeply
understand
relationships

03
– feeling
misunderstood – and
create more
clients' satisfying, long-
motivations, lasting
fears, and partnerships
objectives

Behavioral Finance