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Behavioural Finance

The document discusses two identical restaurants with the same menu, prices and decor, except one is empty while the other is full. It also mentions that the person's best friend recommended the empty restaurant. In 3 sentences: The document describes a choice between two identical restaurants - one that is empty and one that is full, even though they have the same food and prices. It adds that the person's best friend recommended the empty restaurant. Faced with this scenario, most people would choose the full restaurant despite the friend's recommendation, due to herd behavior and preference for popularity.

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135 views

Behavioural Finance

The document discusses two identical restaurants with the same menu, prices and decor, except one is empty while the other is full. It also mentions that the person's best friend recommended the empty restaurant. In 3 sentences: The document describes a choice between two identical restaurants - one that is empty and one that is full, even though they have the same food and prices. It adds that the person's best friend recommended the empty restaurant. Faced with this scenario, most people would choose the full restaurant despite the friend's recommendation, due to herd behavior and preference for popularity.

Uploaded by

jane
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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How would you choose between two

identical restaurants with the same menu,


prices and decor, one of which is empty,
and the other full? And if your best friend
had recommend the former?

Behavioural
Finance

What is Behavioural Finance?

Behavioural Finance is the study


of the influence of psychology on
the
behaviour
of
financial
practitioners and the subsequent
effect on markets.
Behavioural finance is of interest
because it helps explain why and
how markets might be inefficient.

Introduction
During the 1990s, a new field known
as behavioral finance began to
emerge in many academic journals,
business publications, and even local
newspapers. The foundations of
behavioral finance, however, can be
traced back over 150 years. Several
original books written in the 1800s
and early 1900s marked the beginning
of the behavioral finance school.

1. Originally published in 1841,


MacKays Extraordinary Popular
Delusions And The Madness Of
Crowds presents a chronological
timeline of the various panics
and schemes throughout history.
This work shows how group
behavior applies to the financial
markets of today.

2. Le Bons important work, The


Crowd: A Study Of The Popular
Mind, discusses the role of
crowds (also known as crowd
psychology) and group behavior
as they apply to the fields of
behavioral
finance,
social
psychology,
sociology,
and
history.

3.
Seldens
1912
book
Psychology Of The Stock Market
was one of the first to apply the
field of psychology directly to the
stock
market.
This
classic
discusses the emotional and
psychological forces at work on
investors and traders in the
financial markets.

These three works along with several


others form the foundation of applying
psychology and sociology to the field of
finance. Today, there is an abundant
supply of literature including the phrases
psychology
of
investing
and
psychology of finance so it is evident
that the search continues to find the
proper balance of traditional finance,
behavioral finance, behavioral economics,
psychology, and sociology.

The uniqueness of behavioral finance is its


integration and foundation of many different
schools of thought and fields. Scholars,
theorists, and practitioners of behavioral
finance have backgrounds from a wide range
of disciplines. The foundation of behavioral
finance
is
an
area
based
on
an
interdisciplinary approach including scholars
from the social sciences and business
schools. From the liberal arts perspective,
this includes the fields of psychology,
sociology, anthropology, economics and
behavioral economics. On the business
administration side, this covers areas such as
management, marketing, finance, technology
and accounting.

The Foundations of Behavioral Finance

Figure
1
demonstrates
the
important
interdisciplinary relationships that integrate
behavioral finance. When studying concepts of
behavioral finance, traditional finance is still
the centerpiece; however, the behavioral
aspects of psychology and sociology are
integral catalysts within this field of study.
Therefore, the person studying behavioral
finance must have a basic understanding of
the concepts of psychology, sociology, and
finance (discussed in Figure 2) to become
acquainted with overall concepts of behavioral
finance.

What is Behavioral Finance?


Behavioral finance attempts to explain and
increase understanding of the reasoning patterns
of investors,including the emotional processes
involved and the degree to which they influence the
decision-making process. Essentially, behavioral
finance attempts to explain the what, why, and how
of finance and investing, from a human
perspective. For instance, behavioral finance
studies financial markets as well as providing
explanations to many stock market anomalies
(such as the January effect), speculative market
bubbles (the recent retail Internet stock craze of
1999), and crashes (crash of 1929 and 1987).

There has been considerable debate over the real


definition and validity of behavioral finance since
the field itself is still developing and refining itself.
This evolutionary process continues to occur
because many scholars have such a diverse and
wide range of academic and professional
specialties. Lastly, behavioral finance studies the
psychological and sociological factors that
influence the financial decision making process of
individuals, groups, and entities as illustrated
below.

In reviewing the literature written on behavioral


finance, our search revealed many different
interpretations and meanings of the term. The
selection process for discussing the specific
viewpoints and definitions of behavioral
finance is based on the professional
background of the scholar. The discussion
within this paper was taken from academic
scholars from the behavioral finance school as
well as from investment professionals.

Behavioral Finance and Academic Scholars


Two leading professors from Santa Clara University,
Meir Statman and Hersh Shefrin, have conducted
research in the area of behavioral finance. Statman
(1995) wrote an extensive comparison between the
emerging discipline behavioral finance vs. the old
school thoughts of standard finance. According to
Statman, behavior and psychology influence
individual investors and portfolio managers regarding
the financial decision making process in terms of risk
assessment (i.e. the process of establishing
information regarding suitable levels of a risk) and
the issues of framing (i.e. the way investors process
information and make decisions depending how its
presented).

Shefrin (2000) describes behavioral finance as


the interaction of psychology with the financial
actions and performance of practitioners (all
types/categories of investors). He recommends
that these investors should be aware of their own
investment mistakes as well the errors of
judgment of their counterparts. Shefrin states,
One investors mistakes can become another
investors profits (2000, p. 4). Furthermore,
Barber and Odean (1999, p. 41) stated that
people systemically depart from optimal
judgment and decision making.

Behavioral
finance
enriches
economic
understanding by incorporating these aspects of
human nature into financial models. Robert Olsen
(1998) describes the new paradigm or school of
thought known as an attempt to comprehend and
forecast systematic behavior in order for investors
to make more accurate and correct investment
decisions. He further makes the point that no
cohesive theory of behavioral finance yet exists,
but he notes that researchers have developed
many sub-theories and themes of behavioral
finance.

Viewpoints from the Investment


Managers
An interesting phenomenon has begun to occur
with greater frequency in which professional
portfolio managers are applying the lessons of
behavioral finance by developing behaviorallycentered trading strategies and mutual funds.

Viewpoints from the Investment


Managers
For example, the portfolio manager for Undiscovered
Managers, Inc., Russell Fuller, actually manages
three behavioral finance mutual funds:
Behavioral Growth Fund, Behavioral Value Fund, and
Behavioral Long/Short Fund).

Fuller (1998) describes his viewpoint of behavioral


finance by noting his belief that people
systematically
make
mental
errors
and
misjudgments when they invest their money. As a
portfolio manager or as an individual investor,
recognizing the mental mistakes of others (a mispriced security such as a stock or bond) may
present an opportunity to make a superior
investment return (chance to arbitrage).

Arnold Wood of Martingale Asset


Management
described behavioral finance this way:

Evidence is prolific that money managers rarely


live up to expectations. In the search for
reasons, academics and practitioners alike are
turning to behavioral finance for clues. It is the
study of us. After all, we are human, and we
are not always rational in the way equilibrium
models would like us to be. Rather we play
games that indulge self-interest. Financial
markets are a real game. They are the arena of
fear and greed. Our apprehensions and
aspirations are acted out every day in the
marketplace. So, perhaps prices are not
always rational and efficiency may be a
textbook hoax. (Wood 1995, p. 1)

four themes of behavioral


finance:
overconfidence,
financial cognitive dissonance,
regret theory,
prospect theory.

Option 1: A sure profit (gain) of P 5,000


Option 2 : An 80% possibility of gaining
P7,000, with a 20% chance of receiving
nothing(P0).
Question: Which option would give you the
best chance to maximize your profits?

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