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Behavioral Finance

Posted in Finance Articles, Total Reads: 4870 , Published on October 30, 2010

Behavioral finance is the study of investor’s psychology while making financial decisions. In traditional framework, a security’s price equals its fundamental value i.e. the discount sum of future returns. The underlying hypothesis that price reflects its fundamental value is known as the Efficient Market Hypothesis. If the market is efficient, there is no arbitrage opportunity. In fact, any deviation from no arbitrage values must trigger an immediate reaction from markets and the rapid disappearance of the mispricing. However, this does not happen every time. Investors often fall prey to their own and sometimes others' mistakes due to the use of emotions in financial decision-making. Behavioral finance tries to understand how people forget the fundamentals and use emotions in financial decision making.


Behavioral finance plays an important role in how stocks move up and down on a daily basis. The stock prices move up and down without any change in the company fundamentals. This is known as crowd behavior. People move in herds to influence stock prices. Theoretically markets are efficient but do not move efficiently. For example, GMR infrastructure announces mega investment plans in construction of airport infrastructure for next few years, its stock price start moving up immediately without looking into prospects, returns or amount of investment to be made in the project. Another example would be Reliance Power IPO. Most of analyst community as well as investors knew that the issue was overpriced and earning would start trickling in as early as 2016 but then also issue was mega success getting oversubscribed many times. What were the reasons? Of course, human psyche which maintained Reliance stocks will never disappoint. Also the euphoria in the market at that time defying the intrinsic or fundamental value theory. As the positive information of excess subscriptions comes, more investors enter the bandwagon.

Behavioral Finance

Most of the crowd (fund managers, investors, analysts) is constantly involved in beating the markets. In a quest to beat the markets, they end up taking decisions based on emotions rather than on fundamental value. Most of these decisions are based on cognitive illusions. These are grouped into two parts as shown below.

• Representativeness: Investor’s recent success continues in future.
• Overconfidence: Sometimes investors in a quest to beat the markets overestimate their predictive skills sometimes assuming that they have more knowledge. Many a times it leads to excessive trading.
• Anchoring: Sometimes investors are so influenced by their earlier observations; they tend to be very slow to react to new piece of information. For example, an investor may be slow to react to some news expecting that earning may follow historical trend.
• Gambler’s fallacy: It arises when the investors inappropriately predict that tend will reverse.
• Availability Bias: The investors place undue weight for making decisions on the most available information.
States of mind with respect to prospects theory
• Loss Aversion: According to this concept, investor is risk seeker when faced with prospect of losses, but becomes risk averse when faced with the prospects of enjoying gains.
• Regret Aversion: It arises from the investors’ desire to avoid pain of regret arising from a poor investment decision. This aversion encourages investors to hold poorly performing shares as avoiding their sale also avoids the recognition of the associated loss and bad investment decision.
• Mental Accounting: It deals with the set of cognitive operations used by the investors to organize, evaluate and keep track of investment activities. Mental accounting violates the economic principle of fungibility.
• Self Control: It requires for all the investors to avoid the losses and protect the investments.

The above examples of cognitive illusions are widely observed but not all investors will suffer from the same illusion simultaneously. The susceptibility of an investor to a particular illusion is likely to be a function of several variables.

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