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.