Behavioral Finance An Overview

Behavioral Finance An Overview

Farzana Abbasi
International Islamic University Islamabad
MS (Finance)
January 2009

ABSTRACT:
This article provides an overview of Behavioral Finance. It is related to
psychological behavior and financial decisions. Finance is so far
considered as purely a quantitative subject which is nothing to do with
psychology, but it is no more a dilemma that the two are interrelated to
each other.

INTRODUCTION:
Human psychology influences decision making in every field of life because, he is the
man who makes the mare go. In conventional approach, field of Finance is always taken
as a quantitative discipline where emotions and personality is completely overlooked. But
it is not the rationale when it comes down to it.
Behavioral finance is a relatively new field that seeks to combine behavioral and
cognitive psychological theory with conventional finance. This field evolved in 1970s
and research had been conducted over in 1980s. Behavioral Finance tells that why
investor makes an error while making decision and how it affects market price and return.
The managers having diverse personality, approach differently towards decision making
of investing in market. In subsequent sections I will describe Efficient Market Theory and
Prospect Theory, Behavioral Theory and some of the characteristics of investors

Behavioral Finance An Overview

personality and its impact on price and return. At the end the discussion will be
concluded.

LITERATURE REVIEW:
Behavioral Finance is an emerging field which has been evolved from theories like
efficient market theory and prospect theory. Literature is available that shows that this
field has not as much highlighted in the past and recently researchers have worked on this
area of finance. Researches give a clear picture of what the behavioral finance is and how
need of studying this topic was felt. It is very closely related with behavioral sciences or
we can say that it is the combination of finance and human behavior/psychology.
Efficient Market Theory:
Efficient Market Theory was at peak in 1970s. This theory says that market is efficient
when all information is given at point in time and price P which is unknown is predicted
and it is equivalent to the actual price (Shiller, 2003). Shiller in his paper described that
the variable that is being predicted must not vary from the actual value. If it is so then
there occurs an error, which is positive if the variance is high and negative if it is low.
Statman (1999) argued that by market efficiency we mean that investors cannot
systematically beat the market and security prices are rational. This theory does not talk
about sentiments involved in forecasting the rational variable (Statman, 1999). He
criticized efficiency market theory with regard to its rationality. Market efficiency fails
when we talk about stock market price bubbles. There the concept of rational price
forecast break down.
Prospect theory:
In 1979 Kahneman and Tversky presented Prospect Theory in which they analyze the
decision under risk. In this paper expected utility theory was opposed and replaced by
prospect theory. According to them most of the investors are loss averse and he further

Behavioral Finance An Overview

elaborated that hypothetical value function is concave for gains and convex for losses.
Meaning thereby that pain for loss is double than the joy for gain of the same amount of
loss. In contrast to utility theory and market efficiency theory, prospect theory considered
that investors have different attitude towards risk and this attitude results in how they
make decision.
Behavioral Finance:
Behavioral Finance is fairly a new field, emerged from behavioral sciences and financial
management. The traditional view is that these two above mentioned fields are poles
apart but finance without behavioral science is incomplete. Several researchers and
practitioners studied certain aspects of behavioral finance like impact on stock market,
capital budgeting, dividend policy etc. Following are some definitions of Behavioral
Finance.
Behavioral Finance is the study of the influence of psychology on the behavior of
financial practioners and the subsequent effect on markets (Sewell, 2007). Behavioral
Finance is a new paradigm of finance theory that seeks to understand and predict
systematic financial market implications of psychological decision-making (Olsen, 1998).
Like standard finance behavioral finance uses some tools like openness to frames and
other cognitive errors, diverse attitudes towards risk, aversion to regret, imperfect selfcontrol and preferences to both utilitarian and value expressive characteristics (Stateman,
1999). Ritter (2003) based behavioral finance on two building blocks, one is cognitive
psychology and the other one is limit to arbitrage. Cognitive means the way people think
and limit to arbitrage is to forecast that when arbitrage forces will be effective or not.
According to Tilson (2005), Behavioral Finance is the area that tells how the emotions
and cognitions play a vital role in influencing investor and stock market anomalies such
as bubbles and crashes.

Behavioral Finance An Overview

Characteristics of Behavioral Finance:
Following are described some of the characteristics of Behavioral finance.
Herd Behavior: Herd Behavior refers as to join any group of people with the perception
of gaining profit. People who have herd like behavior are either very social in nature or
they think of less risk in a group rather than individually. Here concept of diversification
also encounters, as risk is minimized through diversification. The social influence has a
great impact on individual judgment. When people have to make decision in a group they
behave rationally i.e. they think that if all people in a group might not be wrong and
hence, we come into a right decision (Shiller, 2001). On the other hand this kind of
behavior may also cause irrational decisions and thus fluctuations in the market. Because
in noise trading people make judgments with no information and rely only on the group
they belong to (Thaler, 1994).
Overconfident: Overconfidence implies an overly optimistic assessment of ones
knowledge or control over a situation (Phung, 2006). It is the more risky behavior as the
investor or manager, who so ever decision-maker is, overestimates his/her abilities which
can result into excess volatility and speculative bubbles (Johnsson, Lindblom and Platan,
2002). With overconfident behavior, an investor can lose the game just by considering the
situation according to his/her perception and does not take into account elses opinion.
Framing: The notion framing refers to the reference point that is concerned with the way
the idea is presented. People have different styles they convey their message and
communicate with others. They may attract investors by their abilities and thus market
position depends on how well you call investors.
Heuristics: Heuristics can be defined as use of experience and practical efforts to
answer questions or to improve performance (Johnsson, Lindblom and Platan, 2002).
This often leads to rule of thumb for people to make decision. Heuristics tell us the
reason for market irrationality in an inefficient market.

Behavioral Finance An Overview

Anchoring: The term anchoring means that decision-making is based on the past
experience, i.e. an investor has in mind the previous stock position and his/her future
decisions will be relevant to that perception. Hence anchoring is more of tendency of an
individual to focus on recent behavior he/she came across.
Mental Accounting: People place things at different places in their mind, and so their
judgment is also separate for various things (Ritter, 2003). The mental accounting bias
also enters into investing. For example, some investors divide their investments between
a safe investment portfolio and a speculative portfolio in order to prevent the negative
returns that speculative investments may have from affecting the entire portfolio. The
problem with such a practice is that despite all the work and money that the investor
spends to separate the portfolio, his net wealth will be no different than if he had held one
larger portfolio (Albert Phung, 2007).
Self Control: Mental accounting and framing enhances the self-control of an investor.
From an investor point of view self control is the key characteristic for a vigilant and
wise decision-making.
Applications of Behavioral Finance:
Behavioral Finance has its implications in decision-making of every aspect of Finance
that include investment decisions, capital budgeting, dividend policies, capital asset price
model (CAPM) etc. For example, an investor may undervalue equity when inflation is
high due to its wrong cognitions. Also when returns are not so easy to estimate
heuristics/rule of thumb is applied for taking optimal decision. When emotions are
involved in the process, the stock price volatility becomes high (Olsen, 1998). In Capital
budgeting techniques top management has to take optimal level of cost effective values.
Here mental accounting is useful. Hence, Behavioral Finance influences effectively in
decision-making process.

Behavioral Finance An Overview

CONCLUSION:
Behavioral Finance is a new paradigm in which cognitions and psychological factors
combine with Financial Management to emerge another area of research. Prospect
Theory replaced Market Efficient Theory which only talked about rationalism under
certainty but latter theory elaborated judgment under uncertainty or risk. Characteristics
involved in Behavioral Finance are herd like behavior, overconfident, heuristics,
anchoring, mental accounting, framing and self-control. It is applied in investors
behavior, stock pricing, capital budgeting, dividend policy etc.
I have overviewed few of the topics and yet there are a lot more to discuss on Behavioral
Finance. Prospect theory is to be further studied and practical implementations in
Pakistans context can be the area for future research.

REFERENCES:
Johnsson Malena, Lindblom Henrik and Platen Peter, 2002, Behavioral Finance,
Masters Thesis in Finance, School of Economics and Management Lund University
Kahneman Daniel and Tversky Amos, 1979, Prospect Theory: An Analysis of
Decision under Risk, Econometrica
Olsen and Robert, 1998, Behavioral Finance and its Implications for Stock Price
Volatility, Association for Investment Management and Research, Financial Analyst
Journal
Phung Albert, 2006, Behavioral Finance , A Tutorial.
Ritter R. Jay, 2003, Behavioral Finance, Pacific-Basin Finance Journal
Sewell Martin, 2007, Behavioral Finance,
Shiller J. Robert, 2003, From Efficient Markets Theory to Behavioral Finance,
Journal of Economic Perspectives
Shiller Robert, 2001, Bubbles, Human Judgment and Expert Opinion, Coules
Foundation Discussion Paper, Yale University

Behavioral Finance An Overview

Statman Meir, 1999, Behavioral Finance: Past Battles and Future Engagements,
Financial Analyst journal
Thaler Richard, De Bont and Werner, 1994, Financial Decision-Making in Markets
and Firms: A Behavioral perspective, Bureau of Economic Research
Tilson Whitney, 2005, Applying Behavioral Finance to Value Investing, T2 Partners
LLC
http://www.invetopedia.com
http://www.google.com