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Unit 1 behavioural finance to send

  1. Unit 1: Nature, Scope, Objectives and Significance of Behavioural Finance
  2. Behavioural Finance: Introduction Behavioural Finance: • Behavioural Finance denotes the study of finance based on credible assumptions about how people behave, often confirmed by psychological experiments. • Shefrin (2005) in his book on behavioural asset pricing states ‘Behavioural finance is the study of how psychology phenomena impact financial behaviour’.
  3. Behavioral Finance: Introduction Behavioral Finance: • It is a concept developed with the inputs taken from the field of psychology and finance. • It tries to understand various puzzling observations in stock markets with better explanations. • The behaviour of individuals, practitioners, markets and managers is sometimes characterized as irrational.
  4. Behavioral Finance People in standard finance are rational. People in behavioral finance are normal. Meir Statman
  5. Behavioral Finance: Introduction Behavioral Finance: • Some decisions are simple choices like, which brand of toothpaste we will use, how hard we will study in behavioural finance. • Other decisions such as whether we should buy a particular stock, how should we invest in tax saving instruments, etc impact our financial well being.
  6. Why Behavioral Finance?????? • Conventional" or "modern" finance is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). • These theories assume that people, for the most part, behave rationally and predictably. • One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational "wealth maximizers" who seek to increase their own well-being. • Behavioral finance seeks to explain our actions, whereas modern finance seeks to explain the actions of the "economic man"
  7. Why Behavioral Finance?????? • Few of the regularly occurring anomalies in conventional finance are: • The Winner's Curse: a tendency for the winning bid in an auction setting to exceed the intrinsic value of the item purchased • Equity Premium Puzzle  According to the CAPM, investors that hold riskier financial assets should be compensated with higher rates of returns.  Studies have shown that over a 70-year period, stocks yield average returns that exceed government bond returns by 6-7%.  Conventional economic models have determined that this premium should be much lower
  8. Why Behavioral Finance?????? Reasoning of Equity Premium Puzzle by Behavioral Finance:  “Myopic Loss Aversion", a situation in which investors - overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains - take a very short-term view on an investment.  It is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss due to short term volatility.
  9. Behavioural Finance: Introduction 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
  10. Behavioural Finance: Introduction Behavioural finance is divide it into two branches. • Micro Behavioral Finance: – This deals with the behaviour of individual investors. – In this the irrational investors are compared to rational investors (also known as homo economicus or rational economic man) • Macro Behavioral Finance: – This deals with the drawbacks of efficient market hypothesis. – EMH is one of the models in conventional finance that helps us understand the trend of financial markets.
  11. Behavioral Finance: Introduction • Behavioral Finance as a Science: • Science is a systematic and scientific way of observing, recording, analyzing and interpreting any event. • Behavioural Finance has got its inputs from traditional finance which is a systematic and well designed subject based on various theories. • On this basis behavioural finance can be said to be a science .
  12. Behavioral Finance: Introduction • Behavioral Finance as an Art • In art we create our own rules and not work on rules of thumb as in science. • Art helps us to use theoretical concepts in the practical world. • Behavioural finance focuses on the reasons that limit the theories of standard finance and also the reasons for market anomalies created. • It provides various tailor made solutions to the investors to be applied in their financial planning. • Based on above behavioural finance can be said to be an art of finance in a more practical manner.
  13. Behavioral Finance: Introduction Scope: • To understand the Reasons of Market Anomalies: (Like creation of bubbles, the effect of any event, calendar effect etc) • To Identify Investor’s Personalities: Various new financial instruments can be developed to hedge unwanted biases created in financial markets. • Helps to identify the risks and their hedging strategies • Provides an explanation to various corporate activities: Effect of good or bad news, stock split, dividend decision etc. • To enhance the skill set of investment advisors: Done by better understanding of investor’s goal, maintaining a systematic approach to advise.
  14. Behavioral Finance: Introduction Objectives • To review the debatable issues in Standard Finance • To Protect the interest of stakeholders in volatile investment scenario • To examine the relationship between theories of Standard Finance and Behavioral Finance. • To analyse the influence of biases on the investment process because of different personalities in the financial markets. • To examine the various social responsibilities of the subject. • To discuss emerging issues in the financial world.
  15. Behavioral Finance: Introduction Objectives • To discuss the development of new financial instruments to hedge the conventional instruments against various market anomalies • 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 according to behavioral aspects as well as aspects like age, gender, income etc of the investor.
  16. Behavior • Trend is holding – Lets Buy • Good thing I didn’t wait • I will use this correction to increase my position Greed • Don’t want to sell at a loss, lets wait for it to recover • Enough, I am selling it • Good thing I sold everything • I should not have sold Fear