Behavioral Finance

Unit 1 Syllabus: Behavioural Finance: Nature, Scope, Objectives and Significance & Application. History of Behavioural Finance, Psychology: Concept, Nature, Importance, The psychology of financial markets, The psychology of investor behaviour, Behavioural Finance Market Strategies, Prospect Theory, Loss aversion theory under Prospect Theory & mental accounting—investors Disposition effect Course Objective To understand the basic meaning of the subject behavioural finance To understand the investors’ psychology Market strategies Theories of behavioural finance

Behavioral Finance: Meaning Behavioural finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient.

Nature of Behavioral Finance Most people know that emotions affect investment decisions. People in the industry commonly talk about the role greed and fear play in driving stock markets. Behavioural finance extends this analysis to the role of biases in decision making, such as the use of simple rules of thumb for making complex investment decisions. Behavioural finance takes the insights of psychological research and applies them to financial decision

Nature of Behavioral Finance Behavioural finance studies the psychology of financial decision-making. It makes the understanding of investment decision. It is the study of investor’s psychology. It is analytical in nature.

Scope Identify Investor’s Personality Helps to identify risk Provides explanations to various corporate activities Enhance the skill set to investment advisors To understand the market anamalities

Objective of Behavioural Finance To study emerging issues in financial market To understand the psychology of the investors’ To study the change in trends in investment

Objective of Behavioural Finance To study the investment decision Develop the strategy of financial decision Study the scope of investment decision

Psychology Psychology is concerned with all aspects of behaviour and with the thought, feelings, and motivation underlying that behaviour Psychology is defined as the scientific study of human behaviour with the object of understanding why living being behave as they do.

Scope of Psychology Social Psychology Behavioural Psychology Applied Psychology Educational Psychology

Nature of psychology Psychology as science Psychology as social science Psychology as positive science Psychology as applied science

Psychology of financial market Market psychology Boom and cycles Psychology of investors Psychology of the rational man

Psychology of investors’ behaviour Behavioural approach Cognitive approach Psychoanalytic approach Humanistic approach Eclectic approach

Behavioural finance: Market strategy Market timing Buy and hold strategy Technical analysis as tool Behavioural indicators

Psychology of financial market: Modern investment theory says that, at all times, market prices equal fundamental value and that asset returns in the cross-section reflect relative exposures to systematic non-diversifiable risk. Despite decades of data analysis, empirical support for this theory remains thin.

Prospect Theory The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics. The foundation of prospect theory is that investors are much more distressed by prospective losses than they are happy about prospective gains.

Loss aversion theory In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as powerful, psychologically, as gains. This leads to risk aversion when people evaluate an outcome comprising similar gains and losses; since people prefer avoiding losses to making gains.

Mental Accounting Mental accounting theory, framing means that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect. It is a tendency of the brain to create short cuts with how it perceived the information and ending up with outcomes that is difficult to be viewed in any other way. The results of these mental accounting are that it influence decisions in unexpected ways

Investors’ Disposition Effect The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value.

Investors’ Disposition Effect Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. This is irrational behavior, as the future performance of equity is unrelated to its purchase price.