The Advent of Behavioural Finance

Posted by Dr Sakshi Saxena On 19/10/2023 08:03:11

Stock markets across the world exhibit volatile behavior which makes investment decisions difficult for the market participants, whether they are portfolio managers, brokers, and/or investors. Traditional financial models assume that investors use rational advanced mathematical models/techniques for the analysis, required for investment decision-making. “A market is said to be efficient with respect to an information set if the price ‘fully reflects’ that information set” (Fama, 1970). This evolution by Fama has provided a breakthrough in the field of finance. However, in the 1980s, several researchers claimed that not all results were in line with traditional finance models. Stock market anomalies like the January effect, Monday effect, Friday effect, etc. were reported to have provided excess returns or abnormal returns.

The existence of stock market anomalies has challenged numerous established models of rationality. It has been observed in many studies that investors do not always behave rationally and logically. When they choose to invest in the market, they exhibit some level of irrationality as well. Generally, investors incorporate their psychology into finance, which is also a key component in determining the demand and supply for stocks in the market for generating returns that are different from the ones predicted by traditional financial models. As a result of this, Behavioral Finance, a new domain of Finance was born.

Behavioral finance is a study of the psychology of investors, making financial decisions. According to Lintner (1998), “Behavioral finance is the study of how humans interpret and act on information to make informed investment decisions. It employs scientific research on human cognitive and emotional biases to the effect of market prices and returns on various economic decisions”. Behavioral finance is crucially involved in the decision-making process since it has a direct impact on investors' decisions and the efficiency of the decision-making process. As a result, a thorough study of this area aids in the development of an investor's investing plan. The difficulties and inconsistencies of the traditional finance models/techniques have made behavioral finance a crucial research area. The psychology of investors has emerged as a significant factor influencing the financial market during numerous market crises. Behavioral finance tries to go way beyond what traditional finance can explain in terms of the causes of market crashes and other comparisons.

Behavioral Finance attempts to combine psychology with finance. This field aims to study the psychology of investors. Various behavioral biases namely cognitive as well as emotional have been identified which play a very vital role in the financial decision-making of investors. Behavioral biases can be categorized under three grounds:

  1. Biases of judgment,
  2. Errors of preference
  3. Biases associated with living with the consequences of decisions.

Biases of judgment include Overconfidence, Optimism, Hindsight, and Overreaction to chance events. Errors of preference include nonlinear weighting of probabilities; the tendency of people to value changes, not states; the value of gains and losses as a function; the shape and attractiveness of gambles; the use of purchase price as a reference point; narrow framing; tendencies related to repeated gambles and risk policies; and the adoption of short versus long views. Living with the consequences of a decision gives rise to regret of omission and commission, and also has implications regarding the relationship between regret and risk-taking.

Thus, the use of psychology in finance is something that is not new. Individuals used their psychology while making investment decisions in the past. Awareness of relevant psychological biases is crucial for understanding investors’ behavior in the stock market and for finding reasons for the movement of prices in the market. Investors’ investment decision-making depends upon these biases as it affect their vision, risk appetite, goals, etc. They do deviate from logic and rationality. Investment decisions often get complicated due to their personality traits, emotional handling, and mental mistakes. Thus, investors are required to understand their risk tolerance level and portfolio rebalancing according to their investment strategy in order to achieve their desired returns in the future.

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