By
Priya M.M

Behavioral finance is a relatively new field
that seeks to combine behavioral and
cognitive psychological theory with
conventional economics and finance to
provide explanations for why people make
irrational financial decisions

 Over the last 40 years , standard finance has been
the dominant theory
 Academic finance emphasized theories such as
modern portfolio theory and the efficient market
hypothesis
 these theories failed to explain 2008 crash , dot
com bubble etc.
 Only recently, evolving and of increasing
importance field of neuroscience has also won
appreciation from finance industry
 Works of Kahneman (Nobel Prize Winner) is
considered most creditworthy.

 This field of study argues that people are not
nearly as rational as traditional finance theory
makes out. For investors who are curious about
how emotions and biases drive share prices,
behavioral finance offers some interesting
descriptions and explanations.

Behavioral finance is a field of finance that
proposes psychology-based theories to
explain stock market anomalies such as severe
rises or falls in stock price. Within behavioral
finance, it is assumed the information structure
and the characteristics of market participants
systematically influence individuals'
investment decisions as well as market
outcomes.

It is necessary because “technical analysis”
assumes that people act rationally.

 Anyone knowledgeable in financial
market understands that there are numerous
variables that affect prices in the securities
markets. Investors’ decisions to buy or sell may
have a more distinct margin affect impact
on market value than favorable earnings or
promising products.
 The role of behavioral finance is to
help market analysts and investors understand
price movements in the absence of any intrinsic
changes on the part of companies or sectors.

 It provides an overlay to the standard theory.
Theory it provides a framework to understand
“non-rational” investor and market behaviors.
 Investors
 are not totally rational
 often act based on imperfect information
 make “non-rational” decision in predictable
ways

 Markets
may be difficult to beat in the long run
in the short term there are anomalies and
excesses

 The two aspects of behavioral finance are;
The behavior of investor
The behavior of market

 Suppose a lawsuit is brought against a tobacco
company. Investors know that when this has
happened before, the share price of the tobacco
company has fallen. With this in mind, many
investors sell off their holdings in the company.
This selling results in the further decline of the
security's value.

 Investors in other tobacco companies may fear
similar lawsuits knowing that such a lawsuit was
brought against one tobacco company. These
investors may sell off their holdings for fear of loss.
The securities prices of other companies in the
industry consequently decline as well.
 All the while, none of these tobacco companies
took any action or had a judgment against them
that intrinsically lessened their worth. This is the
sort of issue that behavioral finance attempts to
explain.

 Prospect theory
 Regret theory
 Anchoring
 Over-and under reaction

 Meaning
–Tversky and Kanheman (1979) developed the theory
showing how people manage risk.
–Explaining the apparent regularity in human
behaviors when assessing risk under uncertainty.
–People respond differently to equivalent situations
depending on whether it is presented in the context of a
loss or a gain.
–Investors are risk hesitant when chasing gains but
become risk lovers when trying to avoid a loss

Let us say one has to choose between
• SITUATION-2 (i):
a) A sure gain of Rs.2000
b) 25% chance to gain Rs.1000 and 75% chance
to gain nothing
Now choose between

• SITUATION-2 (ii):
a) A sure loss of Rs.7,500
b) 75% chance to loss Rs.10,000 and 25% chance to
lose nothing
• A large majority of people Choose A in situation
2(i) and b in situation 2(ii).
• In first situation the sure GAIN OF 2000 seems
most attractive whereas in second situation the
sure loss is repellent and the chance to lose nothing
induces a preference for taking risk.

 Meaning
 Emotional reaction to having made an error of
judgment.
 Investors avoid selling stocks that have gone down
in order to avoid the regret of having made a bad
investment and the embarrassment of reporting the
loss.
 They find it easier to follow the crowd and buy a
popular stock : if it subsequently goes down ,it can
be rationalized as everyone else owned it.
 Investors defer selling stock that have gone down in
value and accelerate the selling of stock that have
gone up.

Sales professionals typically attempt to
capitalize on this behaviour by offering an
inferior option simply to make the primary
option appear more attract.

• MEANING
– Anchoring is a phenomenon in which in the absence of
better information, investors assume current prices are
about right.
– Anchoring describes how individuals tend to focus on
recent behavior and give less weight to longer time
trends.
– People tend to give too much weight to recent experience,
extrapolating recent trends that are often at odds with
long run average and probabilities
– In the absence of any better information, past prices are
likely to be important determinants of prices today.
Therefore, the anchor is the most recently remembered
price

• XYZ stock had very strong revenue in the last year, causing its
share price to shoot up from $25 to $80.
• One of the company's major customers, who contributed to 50% of
XYZ's revenue.
• Decides not to renew its purchasing agreement with XYZ causes a
drop in XYZ's share price from $80 to $40.
• By anchoring to the previous high of $80 and the current price of
$40, the investor erroneously believes that XYZ is undervalued.
• Keep in mind that XYZ is not being sold at a discount, instead the
drop in share value is attributed to a change to XYZ's
fundamentals.
• In this example, the investor has fallen prey to the dangers of
anchoring

• The most robust finding in the psychology of judgment
needed to understand market anomalies is
overconfidence.
• People tend to exaggerate their talents and
underestimate the likelihood of bad outcomes over
which they have no control.
• The greater confidence a person has in himself, the
more risk there is of overconfidence.
• Managers overestimate the probability of success in
particular when they think of themselves as experts
• People tend to become more optimistic when the
market goes up and more pessimistic when the market
goes down

 In the month of May, 2008 when Sensex was
touching 22000 still investors were predicting
that it will touch 25000 or 30000 without
realizing it was the extreme situation.
 Investors were putting too much weight on
current situation and became optimistic