Unit 1:
Nature, Scope, Objectives and
Significance of Behavioural Finance

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’.

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.

Behavioral Finance
People in standard finance are rational. People in
behavioral finance are normal.
Meir Statman

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.

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"

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

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.

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

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.

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 .

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.

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.

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.

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.

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