Chapter 1

Behavioral Finance
 Learning Objectives

• Explain Behavioral finance as “Modern

Finance”
• Explain the Nature and Scope of Behavioral
Finance
• Describe the Objectives of Behavioral Finance
• Explain the history of Behavioral Finance
 Behavioral Finance: Introduction
Behavioral Finance is a concept developed with the inputs taken from the
field of psychology and finance, which tries to understand various puzzling
observations in stock markets with better explanations.

Nature
• Behavioral Finance is just not a part of finance. It is something which is
much broader and wider and includes the insights from behavioral
economics, psychology and microeconomic theory.
• The main theme of the traditional finance is to avoid all the possible
effects of individual’s personality and mindset

Behavioral finance is divide it into two branches.

• Micro Behavioral Finance
• Macro Behavioral Finance
 Behavioral Finance: Introduction
• Behavioral Finance as a Science
• Behavioral Finance as an Art
Scope
• To understand the Reasons of Market Anomalies:
• To Identify Investor’s Personalities
• Helps to identify the risks and their hedging
strategies
• Provides an explanation to various corporate
activities
• To enhance the skill set of investment advisors
 Behavioral Finance: Introduction
Objectives
• To review the debatable issues in Standard Finance and the interest
of stakeholders.
• To examine the relationship between theories of Standard Finance
and Behavioral Finance.
• To examine the various social responsibilities of the subject.
• To discuss emerging issues in the financial world.
• To discuss the development of new financial instruments
• To get the feel of trend of changed events over years, across various
economies.
• To examine the contagion effect of various events.
• An effort towards more elaborated identification of investor’s
personalities.
• More elaborated discussion on optimum Asset Allocation
 Behavioral Finance: The Traditional
View to Financial Markets
Weak Form
 Historical Information is available
 Future prices of stocks can not be
predicted
 Technical Analysis is of little or no
value
Semi Strong Form Strong Form
 Stock prices adjust all publically  All information is fully reflected in
available information the stock prices
 Few Insiders earn profits, who adjust  Investors respond quickly
their decision making according to  Insider information is of no value
available information
 Fundamental Analysis is of little or
no value
 Behavioral Finance: Limitations of
Efficient Market Hypothesis
• Market imperfections, like delay in information and
Transaction Costs are unexplained.
• EMH deals with absolute price changes but not the
relative price changes of the stocks.
• Random movement of stock prices does not indicate
the direction of movement.
• Other prevalent market anomalies like Low PE effect,
Small firm Effect and The weekend Effect shows
significant deviation from the Efficient Market
hypothesis , hence calls for a need of Behavioral
Finance.
 Behavioral Finance: Standard Finance
versus Behavioral Finance
Standard Finance Behavioral Finance

Standard Finance believes in existence of Rational Markets and Behavioral Finance believe in existence of irrational markets
Rational investors and irrational Investors

Standard helps in building a rational portfolio Behavioral finance helps in building an optimal portfolio

Standard Finance theories rest on the assumptions that Explanations of behavioral finance are in light with the real
oversimplify the real market conditions problems associated with human psychology

Standard Finance explains how investor “should” behave Behavioral Finance explains how “does” investor behave

Standard Finance assumptions believe in idealized financial Behavioral finance assumptions believe in observed financial
behavior behavior