A Comprehensive Analysis of Behavioral Finance: Concepts and Tools

This essay provides a comprehensive overview of behavioral finance, exploring its core concepts, objectives, and applications in investment decision-making. It delves into the psychological factors influencing investor behavior, such as overconfidence, anchoring, representativeness, regret minimization, frame dependence, self-attribution bias, and trending chasing bias. The essay also discusses prospect theory and how individuals make decisions based on potential gains and losses rather than final outcomes. Furthermore, it examines how professionals manage emotions in decision-making and highlights behavioral tools like cost averaging and diversification to mitigate emotional responses to market volatility. The essay concludes that understanding risk tolerance and implementing well-defined investment strategies are crucial for achieving optimal investment returns. Desklib provides access to similar solved assignments and study resources to aid students in their academic pursuits.

Behavioural Finance

Behavioural Finance: Introduction
 The process of decision making involves complex activity.
 Decisions cannot be made in the vacuum by remaining dependent upon the
personal resources and difficult models that fails to take into the account the
situation.
 Analysis of variables relating to the problems in which it occurs is arbitrated by
the psychology of the manager.
 A situation depending upon the decision making activity encompasses not only
the particular problem that is faced by the individual but also extends to the
situation.

Behavioural Finance: Introduction
• While designing the investment portfolio, the investors must take into the
account their financial goals, tolerance level and other constraints.
• The process is better suitable for institutional investors where the behaviour of
individual is susceptible to behavioural biases.
• Behavioural finance is turning out to be an integral element of decision making
procedure since it heavily influences the behaviour of investors performance.
• These investors can enhance their performance by identifying the biases and
errors of judgement to which the investors are susceptible to.

Emergence of Behavioural Finance:
 The main objective of every investment is to make money.
 The investors were showered with ordinary features and lower peace
of mind.
 There also prevailed a large gap between the returns that were
available returns and returns that are actually received that forced
them to search for the reason.
 The investors made irrational investment decision and in identifying
these mistakes the quality of investment decision impacted the
psychology of investors.

Emergence of Behavioural Finance:
Finance to understand the psychological procedure drives such mistakes.
Behavioural finance is not regarded as the new subject in the field of finance and
it is popular in the stock market throughout the world for making investment
decision.
Several investors have considered that the psychology plays a vital role in
ascertaining market behaviour.

Definition of Behavioural Finance:
 According to the words of Lintner, behavioural finance is referred
as the study of how the humans interpret and act on the information
to undertake the informed investment decision.
 Olsen states that behavioural finance does not tries to describe the
rational behaviour or label the process of decision making as faulty,
rather it seeks to understand and forecast systematic implications of
financial market relating to psychological decision procedure.
 Shefrin states that Behavioural finance refers to the application of
psychology that impacts the financial decision making and financial
markets.

Objectives of Behavioural Finance:
• The objectives of behavioural finance is to recognize the personalities of investors. There are
numerous new financial instruments can be developed to hedge the unnecessary biases created
in the financial markets.
• Behavioural finance helps in recognizing the risks and their strategies of hedge.
• Another main objective of Behavioural finance is to provide the description of numerous
business activities. This includes both the impact of good or bad news, stock split and dividend
decision.
• The objective of Behavioural finance is to improve the set of skill investment advisors.
Behavioural finance helps in understanding the goal of investors by maintaining the systematic
approach to instructions.

Objectives of Behavioural Finance:
Behavioural finance helps in reviewing the debatable issues in the standard finance.
Behavioural finance helps in protecting the interest of the stakeholders in the unstable
investment condition.
Behavioural finance asses the relationship amid the theories of standard finance and behavioural
finance.
To assess the effect of biases on the investment procedure due to the diverse characters in the
financial markets.

Objectives of Behavioural Finance:
• Another objective of Behavioural finance is to assess the numerous social
accountabilities of the subject.
• The behavioural finance objectives is to assess the rising issues in the financial world.
• The objectives of Behavioural finance is to converse regarding the new development
of the new financial instruments to hedge the conventional instruments against
numerous anomalies.
• Another objective of Behavioural finance is to sense the trends of changing event over
the years across the numerous economies.

Different biases or behavioural issues:
• The chemicals present in the brains of humans forces a person to make irrational
decisions. This impacts all their investment decisions.
• Investors are normal and not rational.
• Behavioural finance is treated as the booming field of study that aims to reconcile
the discrepancy among the rational valuation and irrational market pricing.

Different biases or behavioural issues:
Overconfidence:
 Overconfidence might be considered as the most obvious
conception in the behavioural finance.
 This happens when an investor places greater confidence in their
ability to predict the outcomes of their investment decisions.
 Overconfident investors are generally under diversified and hence
greatly vulnerable to volatility.

Example how management deal with
emotions in decision making in business:
• For example, the sound of voices of the sales and technical support staff
along with the music while someone is waiting on the phone would
leave all with the sensory perception.
• Does the product has smell that leaves a mark of impression? Does the
texture of the packing and touch and the feel of product similarly
create an influence and are the management use it for their best
advantage?
• There might be an occasions where the astute marketer could exploit
some senses to stimulate the emotional palette further and thereby
making the brand communication more effective.

Prospect Theory:
Prospect theory can be defined as theory of cognitive psychology which describes how people
selects among the two probability alternatives that consists of risks.
Under the prospect theory the outcome of the probabilities is not certain. The theory explains
that individuals make decision depending upon the potential values of losses and gains instead
of the final outcome.
People under the prospects theory uses the losses and gains by using heuristics.

Examples of Prospect Theory
 To understand how the prospect theory is applied an example has been
considered.
 Assuming the probability of insured risk is 1% with probable loss is
$1,000 and premium stands $15.
 If the prospect theory is applied. If Prospect theory is applied, then at
first reference point need to be set. If the frame is set to current wealth,
the decision would be either
 Paying $15 and yielding a prospect of v(-15)
Or
 Entering in a lottery with the probable outcome of $0 that yields
prospect utility of
 As per prospect theory because the lower probabilities are generally
overweighed.
 by the convexity the value function results in loss.

Different biases or behavioural issues:
Anchoring:
 Investors are considered as bad in processing new information.
Anchoring is associated to overconfidence of the investors.
 An investor makes the initial investment decision depending
upon the information that was available to them during that time.
Later the investors get the news that materially impacts any
forecast that they initially made.
 Instead of performing new analysis the investors simply revise
their old analysis.

Different biases or behavioural issues:
Representativeness:
A company may at times announce the string of great quarterly earnings. As a result of
this, the investors assumes the next earnings announcement would probably be
excessive too.
These errors falls under the wide-ranging behavioural finance concept that is known as
representativeness. An investor incorrectly thinks one thing and means something else.
An example of the representativeness is assuming that a good company has the good
stock. This is because the investors unconditionally hate losing money.
Such behaviour is identical for a gambler that makes the series of larger bets with the
hope of breaking even. Conclusively, investors have trouble in forgetting the bad
memories.

Different biases or behavioural issues:
Regret minimization:
The way in which a person trades in future is also impacted by the
results of their earlier trading outcomes.
Investors usually thinks that they should have waited before selling
the stock.
There may be situation where one of their investments might fall in
value and the investors dwell on the time when they could have sold
the stock in exchange of money. These all result in unpleasant
feelings of regret.

Different biases or behavioural issues:
Frame dependence:
 Frame dependence can be defined as the concept that is refers to the tendency of changing
risk tolerance depending upon the direction of the market.
 The willingness of the investors to tolerate risk might decline when the markets are
declining.
 The risk tolerance level of investors might rise when the markets. This results the investors
to purchase the shares on higher value and sell on lower amount.

Different biases or behavioural issues:
Self-attribution Bias
 Investors that suffers from the self-attribution bias have a habit to attribute
successful outcomes to their own actions and bad results to external factors.
 The investors exhibit this bias as the means of self-protection or self-
improvement.
 Investors that are impacted by the self-attributions bias might become
overconfident.

Different biases or behavioural issues:
Trending chasing Bias:
• Investors generally chase previous performance based on the mistaken belief
that the historical returns to determine the future investment performance.
• The tendency may be complicated based on the fact that some products
issuers might increase the advertisement when the previous performance is
higher to attract the new investors.

How do professional deal with emotions in
decision making
 As the financial analyst and investors focuses lot on the technical and analytical
aspects of the investment related decision, this may in turn be termed as the
logical perspective.
 To deal with the emotional aspects of decision making investors usually faces
obstacle to smart investment when it comes to the risk tolerance level.
 Initially, investors generally face the first sign of discomfort by running the risk
of adjusting with their level of risk.
 Successful investment to a great extent administers the emotions of professionals
that regularly prompts change at the exactly wrong time.

How do professional deal with emotions in
decision making
• Professionals deal with the emotional aspects of investment is reacting
with the market movements by changing their comfort and risk tolerance
level in accordance with the market cycles.
• For professional investors emotional risks manifest in the form of stress,
worry and uncertainty.
• To avoid the biases examples the investors also undertake comprehensive
strategies to lower down the impact of poor timing and fund flows.

Behavioural Tools to help decision making
 The most common behavioural tool of investment to assist the manager’s or investors in
making decision is cost averaging and diversification.
 The dollar cost averaging strategy is regarded as the strategy where the equivalent amount
of dollars is invested at the regular, predetermined interval.

Behavioural Tools to help decision
making
Diversification is another method of diminishing the emotional response and
impulse with the market volatility.
Emotional investing that provides the investors with the confidence in their
allocating all through the market.
In market cycles, the diversification strategy helps in providing downward
protection to the investors.
For most of the investors optimization of portfolio comprises of risk free rates of
investment and adjusting with the market changing environment.

Behavioural Finance: Conclusion
 The bottom line is that without the emotions it is easier said than
done but there are certain important considerations that keeps the
investors to chase futile gains or overselling the same in panic.
 Understanding the risk of tolerance level and the risk of
investment forms the important basis of investment decision.
 Active understanding of the markets and what results in bullish
and bearish trends can be termed as very important.
 A well-defined investment strategy and staying in course of
market volatility usually lead to best performance of returns.

References
• Hirshleifer, D. (2015). Behavioral finance. Annual Review of Financial
Economics, 7, 133-159.
• Statman, M. (2018). Behavioral Finance Lessons for Asset Managers. The
Journal of Portfolio Management, 44(7), 135-147.

Thank You