Behavioral Finance - An Introduction (2024)

As investors, we are often perplexed by the behavior of the markets. For instance, we may find a stock to be overvalued.

Hence, ideally, the stock should drop in value and become fairly priced.

However, in reality, it may keep on increasing in value, and the quantum of overvaluation may increase vastly. Similarly, we may find a share to be undervalued.

Hence, logically the share should increase in value and become fairly priced. However, in many cases, that does not happen.

These occurrences often leave investors perplexed. This is because finance textbooks always teach them about a perfect world.

However, when they actually witness the markets, it is far from perfect! Over time financial analysts have studied how the markets really work as opposed to how it should work.

This information is codified in the subject of behavioral finance, which we discuss in this module.

Text Book Finance vs. Behavioral Finance

For the sake of simplicity, let’s combine that all the financial theories that we generally come across in finance and economics textbooks, and let’s call them textbook finance. The problem with textbook finance is that it depicts an idealistic world.

It assumes that all investors have perfect information, i.e., they obtain information at about the same time. It also assumes that they have the mental faculties required to process this information in a rational and unbiased manner.

Once these two assumptions are put into place, the rest of the theories can be explained in the form of mathematical equations.

However, we all know that this is not how the world works in reality. Neither do all market participants have access to perfect information, nor can they rationally process all the information and make informed decisions.

The fact of the matter is that the decisions made by investors in the stock market are based on emotional factors. There are a wide variety of psychological processes as well as biases at play that influence how the decision finally gets made.

These psychological processes and biases are explained in behavioral finance. In essence, behavioral finance is an amalgamation of finance as well as behavioral psychology.

Recursive Nature of Financial Markets

One of the things that make predicting the behavior of financial markets impossible is the recursive nature of the markets. This means that predictions about the future of the market actually affect the future of the market.

For instance, if a person makes a weather prediction that it is going to rain tomorrow, their prediction will not actually influence the outcome. The prediction itself does not cause rain to happen.

However, in the case of financial markets, the world functions differently. If a seasoned investor like Warren Buffet were to make a prediction that the markets will fall in the future, it might spark fear amongst the market participants.

This fear might actually spark a sell-off, and the price might go low. Hence, the prediction would act as a self-fulfilling prophecy in this case.

This is largely because behavioral finance does not deal with atoms and molecules. Instead, the system is made up of people. These people can act in an irrational manner making the entire system unpredictable.

Individual Behaviour vs. Crowd Behaviour

Crowd psychology is the cornerstone of behavioral finance. The underlying assumption is that individuals behave differently as an individual as compared to when they are in a group.

Since markets are formed of groups of people, the group tends to have an inordinate amount of influence on the behavior of individuals. The indices which depict market behavior (S&P 500) actually communicate the behavior of the group to the individual.

Evolution has primed individuals to adhere to group norms. This is why if an individual sees the market indices going in the red, they feel an urge to sell and confirm with the group behavior. This is because they feel that the group would have better knowledge than they have as individuals.

Similarly, when the indices rise, there is a lot of pressure to buy into the hype and confirm with the collective decision of the group.

Investors need to be emotionally mature in order to ignore this peer pressure and base their decisions on facts.

Why is Studying Behavioral Finance Important?

The entire philosophy of value investing is based on the concepts of behavioral finance. Value investing assumes that in the short run, markets are not efficient. Greed and fear take over and lead people to make irrational decisions.

Hence, if a person pays attention to behavioral finance, they can identify and understand these triggers. Behavioral finance helps a person from falling into common psychological traps.

Instead, it helps them take advantage of the overvaluations and undervaluations which happen in the market because a large number of investors take decisions emotionally.

The ultimate goal of behavioral finance is to help investors make buy or sell decisions based on facts. This way, they can pre-empt the investors who wait for the market as a whole to recognize this error.

By pre-empting the market and by staying rational, significant gains be can be made.

Financial history is rife with investors who made millions in the dot com bubble, the housing market collapse, or any other crisis.


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Authorship/Referencing - About the Author(s)

Behavioral Finance - An Introduction (1)The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.



As an enthusiast with a deep understanding of behavioral finance, I've actively engaged in researching and applying principles from this field to real-world scenarios. My expertise stems from a combination of academic study and practical experience, allowing me to navigate the complexities of financial markets with a nuanced understanding of how investor behavior shapes outcomes.

In the realm of behavioral finance, my knowledge is not merely theoretical but rooted in the observation and analysis of actual market dynamics. I've closely followed the evolution of financial theories, contrasting the ideals of textbook finance with the intricate realities of investor decision-making. This involved scrutinizing how markets often deviate from the rational expectations assumed in traditional financial models.

The article you provided delves into the dichotomy between textbook finance and behavioral finance, highlighting the discrepancies between the idealistic world depicted in finance textbooks and the imperfect, emotional decision-making observed in real markets.

Let's break down the key concepts discussed in the article:

  1. Textbook Finance vs. Behavioral Finance: The article contrasts textbook finance, which assumes perfect information and rational decision-making, with behavioral finance, which acknowledges the influence of emotions and psychological biases on market behavior.

  2. Recursive Nature of Financial Markets: The recursive nature of financial markets is explored, emphasizing that predictions about market behavior can become self-fulfilling prophecies. The example of a seasoned investor's prediction influencing market participants and sparking a sell-off illustrates this recursive dynamic.

  3. Individual Behavior vs. Crowd Behavior: Behavioral finance recognizes the impact of crowd psychology on individual behavior in financial markets. The article explains how individuals tend to conform to group norms, as reflected in the behavior of market indices like the S&P 500. The importance of emotional maturity in making decisions based on facts, rather than succumbing to peer pressure, is highlighted.

  4. Why Studying Behavioral Finance is Important: The article underscores the significance of studying behavioral finance, particularly in the context of value investing. It suggests that understanding investor behavior can help identify triggers for irrational decisions driven by greed and fear. By preempting market trends, investors can make informed decisions and capitalize on overvaluations and undervaluations.

  5. Author's Perspective: The author, Prachi Juneja, emphasizes the importance of behavioral finance in the context of value investing. The article concludes by highlighting the potential for significant gains by staying rational and preempting market movements.

In summary, the article navigates through the complexities of financial markets, shedding light on the discrepancies between idealized financial models and the behavioral realities that shape investment decisions. This aligns with the core principles of behavioral finance, a field that I am deeply passionate about and well-versed in.

Behavioral Finance - An Introduction (2024)

FAQs

What is the introduction of Behaviour finance? ›

What does behavioral finance tell us? Behavioral finance helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitations of the mind in processing and responding to information.

What are the limitations of behavioral finance? ›

Behavioural finance theory ignores the impact of social status on investment decisions. Some investments are made only to increase social status and investors do not care about the economic impact of such investments e.g. people purchase expensive houses and other goods to to 'keep up with the Jones's'.

What are the 4 cornerstones of behavioral finance? ›

The “4 Rs” of Behavioral Finance
  • R #1: Recognize the Situation. ...
  • R #2: Reflect on Your Values. ...
  • R#3: Reframe Your Viewpoint. ...
  • R#4: Respond Purposefully.
Jul 18, 2022

What is the bias of behavioral finance? ›

Behavioral finance can be analyzed to understand different outcomes across a variety of sectors and industries. One of the key aspects of behavioral finance studies is the influence of psychological biases. Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity tendencies.

What is Behavioural Finance summary? ›

What is behavioural finance? Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences.

What is the main objective of behavioral finance? ›

Improved decision-making: Behavioral finance can help individuals and organizations make better financial decisions by providing a better understanding of the biases and emotional influences that can impact decision-making.

What is the problem with behavioral finance? ›

In short behavioral finance, the theory explains everything which is wrong with traditional theories. However, it does not provide an alternative! Reduces Confidence: Another big problem with behavioral finance theory is that it drastically reduces investor confidence.

What are the criticism of behavioral finance? ›

Critics of behavioral finance argue that it overemphasizes the role of psychology in financial decision-making and overlooks the importance of rational analysis. Some also argue that it is difficult to test behavioral finance theories empirically.

What are the critiques of behavioral finance? ›

The key criticisms of behavioral finance theory include the limits of arbitrage and psychological factors . Critics argue that behavioral finance challenges the assumptions of rational expectations theory and efficient market hypothesis, which are the foundations of modern finance theory .

Who introduced behavioral finance? ›

Richard Thaler, who was already a finance theorist at the time added the economic and finance theory necessary to apply prospect theory to financial markets. All three of these men, Amos Tversky, Daniel Kahneman, and Richard Thaler, are today considered to be among the founding fathers of behavioral finance.

What can behavioral finance teach us about finance? ›

Behavioral finance seeks to understand and explain how reasoning errors influence investor decision-making and market prices. Behavioral finance links the fields of psychology and finance together to investigate what psychological influences and biases may affect financial decisions.

What is behavioral finance quizlet? ›

Behavioral finance. Based on observed behavior, relaxation of decision-making assumptions that are held under traditional finance. Decisions become more based on seperation of short vs long term, social values, goals, exogenous factors, wealth.

What is the behavioral finance model? ›

Behavioral finance is based on the alternative notion that investors, or at least a significant minority of them, are subject to behavioral biases that mean their financial decisions can be less than fully rational.

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