Unit-1

Susanta Kumar Mishra

Assistant Professor
Department of Business Administration
 Introduction
 Since the mid-1950s, the field of finance has been
dominated by the traditional finance model developed by
the economists of the University of Chicago. The Central
assumption of the traditional finance model is that the
people are rational. Standard Finance theories are based
on the premise that investor behaves rationally and stock
and bond markets are efficient.
 As the financial economists were assuming that people
(investors) behaved rationally while making financial
decisions, psychologists have found that economic
decisions are made in an irrational manner, so they
challenge this assumption of standard finance. Cognitive
error and extreme emotional bias can cause investors to
make bad investment decisions, thereby acting in
irrational manner.
 Introduction
 Since the past few decade, field of Behavioural finance has
evolved to consider how personal and social psychology
influence financial decisions and behaviour of investors in
general. The finance field was reluctant to accept the view of
psychologists who had proposed the Behavioural finance
model.
 Behavioural finance was considered first by the psychologist
Daniel Kahneman and economist Vernon Smith, who were
awarded the Nobel Prize in Economics in 2002.
 This was the time when financial economist started believing
that the investor behaves irrationally. Human brains process
information using shortcuts and emotional filters even in
investment decisions. It is an attempt to explain how the
psychological dimensions influence investment decisions of
individual investor, how perception influences the mutual
funds market as a whole.
 Introduction
 Behavioural finance is a concept developed with the inputs
taken from the field of psychology and finance.
 It tries to understand the various puzzling factors in stock
markets to offer better explanations for the same.
 These factors or abnormalities were initially termed as
market anomalies, as they could not be explained in the
Neo-classical framework.
 To answer the increased number and types of market
anomalies, a new approach to financial markets had
emerged- the Behavioural finance.
 Behavioural finance is defined as the study of the influence
of socio-psychological factors on an asset’s price.
 It focuses on investor behaviour and their investment
decision-making process.
CONCEPT OF BEHAVIOURAL FINANCE
 Behavioural Finance (BF) is the study of investors’
psychology while making financial decisions.
 It is the study of the influence of psychology and sociology
on the behaviour of financial practitioners and the
subsequent effect on market.
 According to Behavioural finance, investors’ market
behaviour derives from psychological principles of decision-
making to explain why people buy or sell stock.
 Behavioural finance focuses upon how investor interprets
and acts on information to take various investment
decisions.
 Behavioural finance can be explained as modern finance in
which it seeks the reasons of stock market anomalies by
justifying them with explanation of various biases that the
investor has while taking investment decisions.
Behavioural finance is the combination of
psychology, sociology and finance.
 Definitions
 Sewell has defined Behavioural finance as “the
study of the influence of psychology on the
behaviour of financial practitioners and the
subsequent effect on markets”.
 Linter has defined Behavioural finance as “study of
how human interprets and act on information to
make informed investment decisions”.
 According to Shefrin, “Behavioural finance is the
application of psychology to financial behaviour –
the behaviour of investment practitioners.”
 Nature of Behavioural Finance
1. Interdisciplinary Approach: Behavioral finance combines
psychology, sociology, and economics to provide a deeper
understanding of financial behavior. It examines how human
psychology affects decision-making in financial markets.
2. Focus on Irrationality: Unlike traditional finance, which assumes
rational decision-making, behavioral finance acknowledges that
individuals often deviate from rationality due to biases, emotions,
and heuristics.
3. Behavioral Biases: Common biases explored in behavioral
finance include overconfidence, loss aversion, anchoring, and
herd behavior, which impact investment and consumption choices.
4. Empirical Orientation: Behavioral finance relies on empirical
studies and experiments to validate its theories and provide
evidence for behavioral patterns.
 Scope of Behavioural Finance
o To understand the reasons for market anomalies
o Even while normal finance theories can explain the stock
market to a large extent, there are still numerous market
oddities, such as the emergence of bubbles, the effect of any
event, the calendar effect on stock market activity, and so
on.
o Standard finance leaves many market abnormalities
unsolved, whereas behavioural finance offers explanations
and solutions to a variety of market irregularities.
o To identify investor’s personality
o An in-depth look at behavioural finance can aid in
recognising the many types of investor personalities.
o Various new financial instruments can be devised to hedge
the unwanted biases caused in the financial markets once
the biases of the investor's behaviours are detected through
the study of the investor's personality.
 Scope of Behavioural Finance
o To enhance the skill set of investment advisors
o This can be done by providing a better understanding of
the investor’s goals, maintaining a systematic approach to
advice, earning the expected return, and maintaining a
win-win situation for both the client and the advisor.
o Helps to identify the risks and develop hedging
strategies
o Because of various anomalies in the stock markets,
investments these days are not only exposed to the
identified risks but also the uncertainty of the returns.
Significance of Behavioural Finance
1. Challenging Traditional Assumptions: It provides a more realistic view
of financial markets by highlighting the limitations of rationality and
market efficiency.
2. Improving Investment Strategies: By understanding behavioral biases,
investors can devise strategies to mitigate their impact and improve
returns.
3. Designing Better Financial Products: Insights from behavioral finance
help in creating financial products tailored to actual human behavior,
enhancing their usability and effectiveness.
4. Enhancing Financial Education: Awareness of behavioral biases helps
individuals and institutions make more informed and rational financial
decisions.
5. Policy Formulation: Behavioral finance supports the development of
policies and interventions aimed at protecting investors and ensuring
market stability.
6. Understanding Crises: It sheds light on the psychological factors that
contribute to financial crises, such as herd behavior and panic selling.
 Applications of Behavioral Finance

1. Investment Strategies : Behavioral finance helps investors

recognize and mitigate biases, improving decision-making
and returns.
2. Policy Design: Insights are used by policymakers to design
nudges that encourage better financial behavior, such as
increasing savings rates.
3. Corporate Finance: Understanding behavioral aspects
assists managers in avoiding irrational decisions related to
mergers, acquisitions, and capital allocation.
4. Personal Finance: Individuals can use behavioral principles
to improve budgeting, saving, and investment decisions.
 Expected Utility Theory
Introduction
Coined initially by Nicolas Bernoulli in 1738
Revised by John Von Neumann and Oskar
Morgenstern in their book Theory of Games and
Economic Behavior (1944).
It stated that the market participants make their
decisions under risk by comparing the expected
utility values of the available alternatives.
Rational investors act to maximize their expected
utility that is calculated as weighted sums of utility
values multiplied by their respective probabilities.
 Expected Utility Theory
Assumptions
 Rationality
 Decision-makers are assumed to be rational and always
select the option that maximizes their expected utility.
 Probability Weighting
 Each outcome is assigned a probability, and the utility of each
outcome is weighted by its probability.
 Utility Function
 Individuals have a utility function U(x), where x represents
wealth or outcomes. The function reflects their risk
preferences.
 Independence Axiom (Von Neumann-Morgenstern Axiom)
 If an individual prefers outcome A over B, and both are mixed
with a third outcome C in the same proportion, the preference
between A and B should remain unchanged.
Expected Utility Theory
Expected Utility Formula
For a given gamble with possible outcomes x1,x2,...,xn
and corresponding probabilities p1,p2,...,pn the expected
utility is calculated as:
EU=p1U(x1)+p2U(x2)+...+pnU(xn)
The decision-maker chooses the option that provides
the highest expected utility.
 Expected Utility Theory
Utility Function and Risk Attitude/Preferences
Different individuals have different attitudes towards
risk, which are reflected in their utility functions.
Risk attitude refers to an individual’s or entity’s
predisposition toward taking or avoiding risk when
making decisions under uncertainty.
It reflects how someone perceives, evaluates, and
reacts to uncertain outcomes, particularly when these
outcomes involve gains or losses.
Categories of risk attitude:
Risk-Averse Individuals
Risk-Neutral Individuals
Risk-Seeking Individuals
 Risk-Averse
 Risk aversion is a type of attitude where
an individual Prefers certain outcomes
over risky ones with the same expected
value.
 Utility function is concave. indicating
diminishing marginal utility of wealth
 Avoids high-risk, high-reward situations
and often seeks to minimize potential
losses.
 Example: Choosing a guaranteed $50
over a 50% chance to win $100.
 Risk-Neutral
 Risk seeking is a type of
attitude or behavior where a
person is Indifferent between
risk and certainty.
 Utility function is linear.
 Views gains and losses in
purely monetary terms, ignoring
variability.
 Example: Valuing a 50%
chance to win $100 the same
as a guaranteed $50.
 Risk Seeking
 Risk seeking is a type of attitude or
behavior where a person prefers
risky outcomes over certain ones
with the same expected value.
 Utility function is convex. Indicating
increasing marginal utility of wealth.
 Thrives on high-risk, high-reward
opportunities.
 Example: Choosing a 50% chance
to win $100 over a guaranteed $50.
Expected Utility Theory
 Rational Decision-Making
 A rational individual maximizes their expected utility,
selecting the option with the highest EU.
 Allais Paradox
The Allais Paradox is a famous decision-making
paradox introduced by French economist Maurice
Allais in 1953.
It demonstrates how human behavior often deviates
from the predictions of Expected Utility Theory (EUT).
It highlights how individuals’ choices under uncertainty
can be inconsistent, particularly when faced with
variations in probabilities.
 Allais Paradox
The Paradox:
 Imagine you are presented with two sets of choices:
Set 1:
Option A: A guaranteed win of $1 million.
Option B: A 10% chance of winning $5 million, an 89% chance of
winning $1 million, and a 1% chance of winning nothing.
Set 2:
Option C: An 11% chance of winning $1 million and an 89% chance of
winning nothing.
Option D: A 10% chance of winning $5 million and a 90% chance
of winning nothing.
What Most People Choose:
• In Set 1, most people choose Option A (the guaranteed $1M),
avoiding the small chance of getting nothing.
• In Set 2, most people choose Option D (the 10% chance at $5M),
because the difference between 10% and 11% feels small.
 Allais Paradox
Why This Is a Paradox:
According to Expected Utility Theory, choices should remain
consistent when probabilities are proportionally reduced. But
here, the preferences shift when the certainty factor is
removed. This contradicts the Independence Axiom of EUT.
Implications of the Allais Paradox:
 People overweight certainty.
 People violate expected utility maximization in real-world
decisions.
 Prospect Theory (by Kahneman & Tversky) explains this by
showing that people are risk-averse for gains and value
certainty disproportionately.
 Building Blocks
 These are key conceptual issues related to financial
investment.
 Explain why investors often act irrationally, leading to
market inefficiencies.
The key building blocks are:
 Heuristics
 Cognitive Biases
 Prospect Theory
 Market Anomalies
 Emotional Influences
 Social & Cultural Factors
 Self-Control & Time Preferences
Heuristics
People use rules of thumb or shortcuts to make
decisions quickly, often leading to biases:
 Availability Bias – Decisions are influenced by
recent or easily recalled events.
 Representativeness Bias – Assuming past trends
will continue indefinitely.
 Anchoring – Relying too heavily on the first piece of
information received.
 Cognitive Biases
Systematic errors in thinking that impact financial
decisions:
 Overconfidence – Investors overestimate their
knowledge and ability.
 Loss Aversion – Losses hurt more than equivalent
gains feel good.
 Herd Mentality – Following the crowd, leading to
bubbles and crashes.
 Prospect Theory
People perceive gains and losses differently:

 Certainty Effect – Overvaluing sure outcomes over

probabilistic ones.
 Reflection Effect – Risk aversion for gains, risk-
seeking for losses.
 Framing Effect – Decisions change based on how
options are presented.
 Market Anomalies
 When markets behave irrationally
 Market anomalies are patterns or deviations from the EMH, which states that
asset prices fully reflect all available information.
 These anomalies suggest that investors do not always act rationally, leading to
opportunities for excess returns.
 Fundamental Anomalies: Suggest that stocks with certain fundamental
characteristics outperform others. ‘Value effect’, and ‘Small-cap Effect’
 Technical Anomalies: These anomalies relate to price trends and investor
behavior. ‘Momentum Effect’, ‘Reversal Effect’
 Calendar Anomalies: Show that certain times of the year, month, or even week
exhibit unusual price movements. Occur because of special preference given to
some specific months, weeks, or days in trade activities. ‘January Effect’,
‘Weekend’ Effect(Monday Effect)’, ‘Sell in May and Go Away’.
 Behavioral Anomalies: arise due to psychological biases affecting investment
decisions. ‘Overreaction & Underreaction’, ‘Disposition Effect’
 Information-Based Anomalies: Occur when markets do not fully absorb
information efficiently
 Bubble & Crash Anomalies: Extreme deviations in asset prices due to speculation
 Emotional Influences
Emotions play a major role in investment decisions:

 Fear and Panic Selling – Exiting markets during

downturns.
 Greed and Overtrading – Chasing high returns and
speculative assets.
 Regret Aversion – Holding onto losing investments
too long to avoid admitting mistakes.
 Social & Cultural Factors
 Social norms – People invest based on societal
trends (e.g., crypto craze).
 Media influence – Financial news and social media
impact investor sentiment.
 Peer pressure – Individuals conform to group
behavior in investing.
Self-Control & Time Preferences
 Hyperbolic Discounting – Preferring smaller
immediate rewards over larger future gains.
 Mental Accounting – Treating money differently
based on its source or use.
 Status Quo Bias – Sticking with default options,
even if change would be beneficial.
 Investment Decision Cycle
Shows a typical cycle of investor emotions, or our
probable responses to the rise and fall of our
investments.
• What sort of emotions you’re likely to experience as
your investments rise and fall?
• How the phases investors pass through along the
cycle of emotions each can be mapped to specific
responses?
• Why we can often end up where we started?
Investment Decision Cycle
 Investment Decision Cycle
Stage one: Reluctance

Occurs at both the start and end of the chart.

This is the default emotional state, simply because

individuals generally fear taking a risk and getting it

wrong, more than they worry about missing out.
This reluctance to get involved is compounded by

another strong behavioural effect: loss aversion.

Investment Decision Cycle
Stage two: Optimism, excitement and
(irrational) exuberance
Reluctance starts diminishing when markets
pick up and the economy enters a positive
phase.
Fear of loss quickly turns into a fear of
missing out.
Our natural aversion to loss may now cause
us to take action to increase short-term
emotional comfort, this time by entering the
market.
 Investment Decision Cycle
Stage three: Denial, fear, desperation and panic
Investors always try to compute gains and losses from the
point at which they enter the market.
Only those investors who are in immediate need of liquidity
try to sell the holdings, but remaining investors hesitate to sell
the stocks in loss ( i.e prefer to hold loss making securities).
 But further fall in the market price leads them to panic
situation.
 Few of the investors may be found to sell their investments
for reasons other than liquidity needs.
 Thus we see fall in price a common phenomenon in all these
points, only difference is volume.
 Volume which is dried up at denial stages bursts at panic
stage.
 Investment Decision Cycle
 Stage four: Capitulation, despondency, depression, apathy,
indifference…and reluctance again
 On the way down, loss aversion and denial tends to cause
investors to hold on to their investments.
 As their portfolio plummets, the emotional pain of selling at a
loss increases too, but at a diminishing rate.
 Losing 5% hurts, but the first 5% hurts the most.
 Once you‘ve already lost 30%, the difference between -35% and
-30% feels less significant than the difference between -5% and
no loss at all.
 The point of despondence can be explained as a point of
maximum safety.
 Hence buying process starts due to emotional safety assumed
by investors.
 When volume of buying gradually increases, there will be
phases like depression, apathy and indifference.
 Judgement under uncertainty
Heuristics are shortcuts and rule of thumb
approaches used by human mind while
making a decision on variable which are
highly uncertain.
Such use of heuristics can cause bias and
lead to irrational responses from investors.
In 1974, two brilliant psychologists, Amos
Tversky and Daniel Kahneman described
three heuristics that are employed when
making judgments under uncertainty.
 Judgement under uncertainty
Heuristics:
 Representativeness Heuristics : Judging probability
based on similarity rather than statistical logic.
Example: A person reads a description: "Steve is shy,
withdrawn, and loves to read." They assume Steve is more
likely to be a librarian than a farmer.
 Availability Heuristics Estimating likelihood based on
how easily examples come to mind. Example: After
seeing news reports about plane crashes, people overestimate
the risk of flying, despite it being safer than driving.
 Anchoring and adjustment Heuristics: Relying too
heavily on the first piece of information encountered.
Example: A car salesman first shows a high-priced model
before a mid-range option. The mid-range price seems
reasonable in comparison.
 Judgement under uncertainty
• Biases: Systematic errors in thinking caused by
heuristics.
 Overconfidence bias: People tend to be more
confident in their judgments than is statistically
warranted. Example: 80% of drivers think they are
better than average, which is statistically impossible.
 Base rate neglect: Ignoring general statistical
information in favor of specific details.
 Hindsight bias: Seeing past events as more
predictable than they actually were. Example: After a
stock market crash, people claim they saw it coming, even
though they didn’t predict it before.
Cognitive information perception
Cognitive perception includes, aside from the
senses listening, seeing, smelling, tasting and
feeling, the way in which we deal with information.
While perception refers to ways of obtaining
information from our environment, cognition
describes processes such as remembering,
learning, solving problems and orientation.
For understanding of cognitive information
perception, understanding of working of these two
systems of human brain is important.
Psychologists Keith Stanovich and Richard West
refer to them as System 1 and System 2
Cognitive information perception
 Cognitive information perception
System 1 operates automatically and rapidly. It
requires little or no effort and is not amenable to
voluntary control.
System 2 is effortful, deliberate and slow. It requires
mental activities that may be demanding, including
complex calculations.
 As Daniel Kahneman put it, ―The operations of
system 2 are often associated with the subjective
experience of agency, choice and concentration.
 People tends to be overconfident in dealing with
things which they presume to be familiar and
provides answers based on system – 1 which uses
heuristics instead of complex calculations.
 Stages of Cognitive Information
Perception
Cognitive information perception refers to how our
brain processes, interprets, and understands
incoming information.
This process is influenced by attention, memory,
heuristics, and biases, shaping how we perceive
and react to the world around us.
 Stages of Cognitive Information
Perception
 Sensory Input
• Information enters through sensory organs (eyes, ears, skin, etc.).
• Example: Seeing a red traffic light.
 Attention
• The brain filters and focuses on relevant information while ignoring distractions.
• Example: In a noisy café, you focus on a friend’s voice while ignoring background
chatter.
 Interpretation & Processing
• The brain categorizes and makes sense of information based on past experiences
and knowledge.
• Example: A doctor quickly diagnosing a cold based on common symptoms.
 Memory Integration
• New information is stored and linked to existing memories and schemas (mental
frameworks).
• Example: Remembering a face but struggling to recall the name.
 Decision-Making & Action
• Perceived information influences judgments and actions.
• Example: Hearing thunder and deciding to take an umbrella before going outside.
 Factors Influencing Information Perception
 Cognitive Biases
• Selective perception: We focus on information that aligns with our expectations.
• Confirmation bias: We seek out and remember information that supports our beliefs.
• Framing effect: The way information is presented influences decisions. Example: A
"90% success rate" sounds better than a "10% failure rate," even though both mean the
same thing.
 Heuristics (Mental Shortcuts)
• Availability heuristic: Judging likelihood based on how easily examples come to mind.
Example: Thinking shark attacks are common after watching a news report about one.
• Representativeness heuristic: Judging based on similarity rather than probability.
Example: Assuming someone is a scientist because they wear glasses.
 Emotions & Psychological State
• Fear & anxiety: Heighten risk perception. Example: A fearful person sees more threats in
their environment.
• Mood-congruence effect: Current emotions influence what we remember and notice.
Example: When happy, we recall more positive memories.
 Cultural & Social Influences
• Language & symbols: Different cultures interpret gestures and words differently.
• Social norms: What is considered "normal" varies by culture and experience. Example:
Eye contact is seen as confidence in some cultures but rudeness in others.
PECULIARITIES OF QUANTITATIVE AND
NUMERICAL INFORMATION PERCEPTION
People including the investment community had
their own problems in understanding the
computations in mathematics.
This is especially true in their capability to deal
with probability concept.
Bias in terms of quantitative and numerical
information perception is an unavoidable fact.
PECULIARITIES OF QUANTITATIVE AND
NUMERICAL INFORMATION PERCEPTION
 Money illusion refers to the way individuals react to
inflation and its impact on investment performance.
 People tend to think naturally in terms of nominal
amounts.
 That is, they look at the overall investment return without
regard for the level of inflation and the resulting real
return.
 This leads to positive reactions to high returns no matter
what the level of inflation and resulting real return.
 Of course the opposite is also true.
 Investors tend to react negatively to low returns, even if
inflation is more or less nonexistent.
 PECULIARITIES OF QUANTITATIVE AND
NUMERICAL INFORMATION PERCEPTION
True probabilities : People due to their familiarity or otherwise
tends to overestimate the probability or underestimate it even
though numerically they have equal chances of occurrence.
Big numbers and small numbers : Another irrational attitude
is identified in choosing between numbers is the tendency of
choosing the bigger number and ignoring smaller numbers.
Base rate v/s case rate : To understand the fundamental
strength of an entity at the time of investment, base rate cannot
be ignored. But the limited cerebral capabilities in processing
vast information for the purpose of understanding the base rate
automatically avoids such cumbersome calculations and
searches for a shortcut route of considering the case rate as a
substitute for it. Case rate means processing currently available
small amount of information.
 References
1. Behavioral Finance: Psychology, Decision-Making, and
Markets", by Ackert and Deaves.
2. The Psychology of Investing by John R.
3. Understanding Behavioral Finance by Ackert Nofsinger,
Pearson Prentice Hall, (4th Edition)
4. What Investors Really Want - Learn the lessons of
behavioral Finance, Meir Statman, McGraw-Hill
5. Handbook of Behavioral Finance – Brian R. Bruce
6. Behavioral finance - Wiley Finance - Joachim Goldberg,
Rüdiger von Nitzsch