Behavioral Finance

OBJECTIVE OF STUDY:

Following are the objectives of the study undertaking:

 To understand the concept of Behavioral Finance

 To understand the evolution of behavioral finance and the difference

between efficient markets and behavioral Finance

 To understand the various theories of Behavioral Finance

 To briefly answer the question “Why do investors behave in a particular way?” CHAPTER-1

INTRODUCTION:

According to the Modern Portfolio theory or the Efficient Markets Hypothesis, as given my Eugene Fama (1969), Financial markets are remarkably efficient and investors are completely rational. The theory is based on the notion that investors act rationally and consider all available information in the decision-making process, and hence investment markets are efficient, reflecting all available information in security prices. Markets were presumed to be uniform and efficient and all market investors to be sophisticated and informed.

However, researchers have uncovered a surprisingly large amount of evidence of irrationality and repeated errors in judgment. Behavioral Finance or behavioral economics, even though controversial, is a revolution that has occurred in the field of finance and economics. Behavioral Finance explains how emotion and psychology play a role when investors make decisions, sometimes causing them to behave in unpredictable or irrational ways.

The theory understands that people are complex and hardly ever act rationally, and since Financial Institutions are designed for people, its functioning in turn depends on the investors and their behavior.

CHAPTER-2

BACKGROUND TO BEHAVIORAL FINANCE:

The models within the traditional finance paradigm assume that investors act rationally and consider all available information in the decision-making process.

Hence, investment markets were presumed to be:

a) Efficient and

b) Security prices reflect the true ‘intrinsic values’ of the assets.

c) Investors efficiently take account of all information and come to market prices that are perfect.

It concluded that since the ‘prices are right’, reflecting all available information and there is no ‘free lunch’: i.e. there is no way one can make money in a market that reflects the prices so efficiently.

Note that market efficiency does not suggest that individuals are ill – advised to invest in stocks. Nor does it suggest that all stocks have the same expected return. The efficient market hypothesis in essence says that while an investment manager cannot systematically generate returns above expected adjusted risk returns, stocks are priced fairly in an efficient market.

CHALLENGING THE EFFICIENT MARKET HYPOTHESIS:

Market efficiency, in the sense that market prices reflect fundamental market characteristics and that excess returns on the average are leveled out in the long run, has been challenged by behavioral finance.

There have been a number of studies pointing to market anomalies that cannot be explained with the help of standard financial theory, such as abnormal price movements in connection with initial public offerings (IPOs), mergers, stock splits and spin-offs.

Throughout the 1990s and 200s statistical anomalies have continued to appear which suggest that existing standard finance models were , if not wrong, probably incomplete.

Investors have been shown not to react “logically” to new information, but to be overconfident and to alter their choices when given superficial changes in the presentation of information.

As such, the behavioral finance paradigm has emerged in the response to the difficulties faced by the traditional paradigm. In essence, it argues that:

a) Investment choices are not always made on the basis of full rationality.

b) People are rarely rational and have limits of their own.

c) Some information in the market is neglected and other exaggerated

d) There are limits to arbitrage [Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the price], which allows investor irrationality to be substantial and have long-lived impact on prices.

Behavioral finance talks about the biases that arise when people form beliefs, preferences and the way in which they make decisions, given their beliefs and preferences (Barberis and Thaler, 2003). People are influenced by each other; there is a social pressure to conform to. As such, limit to arbitrage and psychology are seen as the two building blocks of behavioral finance

The top Behavioral Issues for Finance are as follows:

1. Overconfidence

2. Loss aversion

3. Regret

4. Mental Accounting

5. Probability mistakes

6. Herd Behavior

7. Cognitive Dissonance

I have explained the behavioral theories that explain the various irrational investor behaviors in the following chapters.

CHAPTER-3

PROSPECT THEORY

Prospect theory was created in 1979 and developed in 1992 by Daniel Kahneman and Amos Tversky .

Prospect theory describes how people form decisions about different prospects or