Behavioral Finance

ByPriya M.M

Introduction 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

History 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.

Meaning 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.

Definition 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.

Why Is It Important?

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

Why It Matters? 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.

Behavioral finance 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

Aspects of BF

The two aspects of behavioral finance are;

The behavior of investor The behavior of market

How it works (example):

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.

Theories of BF Prospect theory Regret theory Anchoring Over-and under reaction

Prospect theory 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

Example of the theory

Let us say one has to choose between• SITUATION-2 (i):

a) A sure gain of Rs.2000b) 25% chance to gain Rs.1000 and 75% chance to gain nothing

Now choose between

• SITUATION-2 (ii):

a) A sure loss of Rs.7,500b) 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.

Regret theory 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.

Example of the theory

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

Anchoring• 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

Example of the theory• 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

Over and under reaction• 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

Example of the theory

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

Thank you