Introduction to Behavioural finance
Behavioral finance is commonly defined as the application of psychology to understand human
behavior in finance or investing. It is the study of the influence of psychology on the behavior of
investors or financial analysts. It also includes the subsequent effects on the markets. Behavioural
finance is the study of the influence of psychology on the behaviour of financial practitioners and
the subsequent effect on markets.
The credence of the new dimension of Behavioral Finance is being defined as the application of
psychology to finance. The evolution of this proliferated section explains the way of thinking
process of investors counting with the emotional cycle, which actually intervene in the decision
making process. Behavioral finance is being built on the basic tilt of understanding of the fields
like Psychology, Sociology and Finance (Ricciardi & Simon, 2000).It combines twin disciplines
Psychology and economics to explain why and how people make seemingly irrational or illogical
decisions when they spend, invest, save and borrow money. Behavioural finance is a rapidly
growing area that deals with the influence of psychology in the behaviour of financial practitioners.
Definitions
Shefrin 2000, Behavioural finance is the appliaiton of psychology to financial behaviour – the
behaviour of practitioners”
Shefrin (2001)Behavioural finance is the study of how psychology affects financial decision
making and financial markets
According to Fromlet (2001) “Behavioural finance closely combines individual behaviour and
market phenomena and uses knowledge taken from both the psychological field and financial
theory” (Fromlet, 2001)
M Sewell (2007) “Behavioural finance is the study of the influence of psychology on the
behaviour of financial practitioner and subsequent effects on market.” He has stated Behavioural
Finance, challenging the theory of Market efficiency by providing insight into why and how
market can be inefficient due to irrationality in human behaviour.
Meir Statman of Santa Clara University has said that people in standard finance are rational,
whereas people in behavioral finance are normal.
It focuses on the fact that investors are not always rational, have limits to their self-control, and
are influenced by their own biases.
As you are probably aware, the term “behavioral finance” appears in many books, newspapers and
other media outlets, but many people still lack a clear understanding of the concepts behind
behavioral finance, or what is meant by the term. One cause of this confusion is that many similar
topics are discussed in the mainstream media, namely:
behavioral science
investor psychology
cognitive psychology
behavioral economics
experimental economics
cognitive science
Understanding Behavioral Finance
To make understanding of Behavioural finance easier we will have a glance on the traditional
approach to teaching behavioral finance and break behavioral finance into two subtopics:
behavioral finance micro, and
behavioral finance macro
Behavioral Finance Micro versus Behavioral Finance Macro
Behavioral finance micro (BFMI): examines the behavioral biases (that is, the irrational
behaviors) of individual investors. BFMI compares irrational investors to rational investors, as
envisioned in classical economic theory, also known as “homo economicus,” or rational economic
man.
Behavioral finance macro (BFMA): describes anomalies or irregularities in the overall market
that contradict the efficient market hypothesis (which is described later). BFMA envisages that
markets are efficient, but that abnormal market behaviors occur, such as the January effect (and
others discussed later), that demonstrate that human behavior influences securities prices and,
therefore, markets.
What are we focusing now?
As per syllabus the first 4 units cover individual investor behavior and the last unit is about
Behavioural corporate finance. As of now our primary focus is BFMI, or the study of individual
investor behavior.
Purpose studying Individual investor behavior
Fund managers are using behavioral finance concepts to select stocks and construct portfolios.
In the study of individual investor behavior
• Identify relevant psychological biases our clients might have and investigate their influence
on asset allocation decisions.
• Fund managers can then try to manage the effects of those biases on the investment process
and help their clients meet their financial goals
Now the question is what behavior do individuals possess?
Do individual investors behave rationally, or do cognitive (relating to conscious intellectual
activity such as thinking, reasoning, and remembering) and emotional errors affect their financial
decisions?
As a student of behavioral finance, one needs to understand that most of the economic and financial
theories are based on the assumptions that individuals act rationally and consider all available
information in the financial decision-making process.
However, over the years many academic researchers have collected and documented evidence of
irrational behavior and repeated errors in financial judgment.
We can learn a lot from this research if we take the time to understand and interpret it. The most
fundamental topic in behavioral finance research is:
1. The classic debate of homo economicus (rational economic man) versus the behaviorally
biased human.
2. The Standard finance versus Behavioral finance
3. The Efficient Markets versus Irrational Markets
We will be discussing these in detail in the next lecture
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