Behavioral Finance Theory and Application.pdf
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The journey of behavioural finance has not been an easy one. Although psychology and
behaviour have been linked with financial phenomena in the past, the research in this
area has been sporadic and remained at the borders of mainstream finance. It was not
until the late 20th century that the discipline received the recognition it deserved. This
happened with Kahneman and Tversky introducing the groundbreaking “prospect the￾ory” in 1979 and receiving the Nobel Prize for the same. Since that time, this discipline
has revolutionised the way we perceive traditional finance. It highlights the fact that we
are dealing with real people in the real markets that are far from being either perfect or
rational.
Emotions rule the market as well as our decisions. They have been responsible for
creating disruptions in the market that could no longer be satisfactorily explained by
rational models like Markowitz portfolio theory or the capital asset pricing model. Thus,
behavioural studies have become essential to finance. As a result, this discipline has
grown by leaps and bounds in recent times with notable research contributed by experts
such as Richard Thaler, Robert Shiller, Andrei Shleifer, Terrance Odean, Hersh Shefrin,
Meir Statman, Nicholas Barberis, John Nofsinger and many significant others. In fact,
the amount of literature in this field has become so extensive that it is a daunting task
to compile every aspect in a single work. Nevertheless, we make an attempt to cover the
major aspects of behavioural finance with this resource.
This resource is an attempt to introduce behavioural finance as a discipline in the light of
the financial decision-making process. It must be kept in mind that although behavioural
finance models and concepts are extremely useful and relevant, they are difficult to imple￾ment. They lack the concreteness of standard finance. Therefore, behavioural finance
cannot completely replace rational finance; it can only supplement it. In this regard, the
resource discusses the existing standard finance models as well as their behavioural coun￾terparts. It analyses the various behavioural biases in detail as well as their influence on
individual and institutional investors. Special emphasis has been laid on the upcoming
areas in this discipline, such as neurofinance, emotional finance, social influence and
moods. A new C on experimental finance has been introduced to elucidate the
importance and usage of experimental design in financial research. The organisation of
the resource is as follows.
The resource is divided into 7 parts and 16 Cs.
Preface xiii
Part I: Behavioural Finance: Foundations and Key Concepts
This part comprises four Cs. C 1 discusses the history of behavioural finance
and the classical and neoclassical approaches to investor and market behaviour. It pro￾vides a continuum of behavioural research that has been done since the time Charles
Mackay documented the first asset pricing bubble, Tulipomania, in 1841. The discus￾sion progresses to the behavioural observations of Adam Smith, Keynes and other nota￾ble researchers of that time. It further talks about the time when traditional theories
dominated the financial arena and subsequently deals with the leakages in the tradi￾tional concepts that led to the evolution of behavioural finance as a discipline. This C identifies that there are two approaches to understanding the markets, namely the
traditional or standard approach and the behavioural approach. These approaches are
extensively explained in Cs 2 and 3. C 2 provides the foundations of tradi￾tional finance that are built on the concept of rationality. It analyses concepts such as the
expected utility theory, Markowitz portfolio theory, capital asset pricing model and the
efficient market hypothesis. Finally, it gives a brief insight into what went wrong with
these theories. C 3 is built on the lacunae of traditional theories mentioned in the
previous C. It discusses the central tenets of prospect theory that provides an alter￾native to the expected utility theory. It further discusses key behavioural concepts such
as framing and mental accounting that can significantly influence the decision-making
process. Further, C 4 analyses the neurological factors behind investor behaviour.
It discusses the role of the human brain in shaping the decision-making behaviour of
individuals. It throws light on concepts such as the triune brain, hormone secretion in the
body and its role in investor decision making. This C establishes the main line of
differences in three disciplines, that is, traditional finance, behavioural finance and neu￾rofinance. It develops an understanding of the neural mechanisms that work behind loss
avoidance and the disposition effect. Most importantly, it also entails a discussion on the
implications of neurofinance for practitioners.
Part II: Behavioural Biases
This part deals with the psychological intricacies of how investors behave. It shows that
consciously or unconsciously we give in to our human nature. This human nature is a
complex intermingling of cognition, emotion, moods and sentiments that can signifi￾cantly influence our decisions. Further, by following our innate urges, we tend to make
financial follies in the market that can cost us dearly. These urges that influence our
behaviour to make mistakes are known as behavioural biases. Owing to their signifi￾cance, the detailed discussion on these biases has been divided into three parts. C
5 gives an overview of various behavioural biases. It analyses the basis of segregation
of biases that could be cognitive or emotional, heuristic-driven or frame-based. This
C also talks about the biases that are a result of two or more psychological factors
which make them difficult to categorise in any of the above-mentioned categories. The
discussion is taken forward with Cs 6 and 7. C 6 talks about the heuristic￾driven biases. It accounts for the evolution of heuristics as a way to simplify the complex
decision-making process. They were considered mental shortcuts for making decisions.
It further segregates the different types of heuristics that are used by the investors over a
period of time. Subsequently, the C talks about how these mental shortcuts mor￾phed into biases of the investors and came to be known as the heuristic-driven biases.
xiv Preface
The C finally discusses the implications of these biases in the portfolio selection
decisions of the investors. C 7 deals with another category of biases that are called
frame-dependent biases. It signifies the role of psychological factors such as moods, emo￾tions and sentiments that have a bearing on our perspective or frame of mind. Driven by
this biased perspective, we fall prey to several behavioural mistakes collectively called the
frame-dependent biases. A detailed account of such select biases is being provided in this
C. The C concludes with the role that regret, responsibility and expert advice
play in the financial decision-making process.
Part III: Market Forces
This section deals with the various forces that can make the markets inefficient. It specifi￾cally focuses on the psychological and emotional forces that govern market behaviour.
Evidence proves that these forces are potent enough to create inconsistencies in the mar￾ket that emerge in the form of anomalies. It further explains that investors can strategise
themselves judiciously to take advantage of such anomalies and gain superior returns.
The discussion on this matter has been divided into two Cs. C 8 analyses the
proponents of the efficient market hypothesis and the challenges faced by them due to the
forces of greed, hope and fear. It gives an account of various market anomalies and the
opportunities they provide to beat the market. Further, it discusses the new age concept
of market efficiency that comes under the purview of the behavioural market hypothesis.
This includes theories such as the functional fixation hypothesis, fractal market hypoth￾esis, adaptive market hypothesis and noisy market hypothesis. C 9 adds on to
C 8 in that it dissects the process of building an investment strategy. It discusses
that broadly there are two types of investment strategies: active and passive. It further
notes that while traditional criteria suggest a passive strategy, the behavioural approach
favours an active strategy. The behavioural approach argues that since the markets are
imperfect, investors can capitalise on the imperfections by actively managing their port￾folio. This can be achieved by following strategies such as the momentum and reversal
strategies, value investing and the use of sentiment indicators to outperform the markets.
The C also explores the contemporary trends in behavioural investing, such as the
role of colours and investors’ personality type in the decision-making process.
Part IV: Emotional and Social Forces
This part deals with the most recent development in the behavioural finance discipline,
that is, the emotional and social forces. This part comprises two Cs. C 10
introduces the concepts underlying emotional finance. It enables the readers to under￾stand the role of emotions, both conscious and unconscious, in investor decision making.
Evidence suggests that emotions have been instrumental in creating asset pricing bubbles.
This C highlights how and why such bubbles happen. It also discusses the appli￾cation of emotional finance theories in real life. C 11 further analyses the role of
social forces such as culture and individual psychological factors, like moods, in affecting
financial behaviour. More specifically, it assists readers in comprehending the impact of
religion on investor decision making. This C firstly builds on the understanding of
various types of social networks and thereafter establishes the contribution of various
forms of societal interactions in the decision-making process. Last but not least, it puts
Preface xv
forward the influence of moods on trading behaviour, financial performance and the
construction of a portfolio with mood effects.
Part V: Institutional Investors’ Behaviour
This part comprises two Cs that provide an in-depth account of the institutional
investors’ decisions and their behavioural discrepancies. C 12 analyses the theo￾retical underpinnings of behavioural biases of institutional investors. It discusses various
psychological, sociological and biological factors that shape investors’ behaviour and
their anomalies. This C describes the most prominent behavioural biases of institu￾tional investors and their subsequent impact on their trading behaviour. It also compares
how the behavioural biases vary between individual investors and institutional investors.
It enables the readers to identify the various factors that lead to heterogeneity in the
behaviour and decision making of institutional investors. C 13 deals with demysti￾fying the behavioural biases of market professionals such as portfolio managers, financial
analysts, financial planners and advisers. It gives an overview of the regulatory regimes of
different investment fund schemes functioning in India. The readers will gain insight into
the impact of behavioural biases of financial professionals on financial decision making.
It builds on concepts like principal-agent conflicts between clients and advisers and pos￾sible solutions to address them. This C further involves a detailed discussion on the
different modes of fee and compensation structures of financial advisers and the agency
costs associated with financial advice.
Part VI: Practical Applications of Behavioural Finance
This part comprises two Cs. C 14 emphasises the salient terminology asso￾ciated with behavioural corporate finance. It deals with behavioural corporate finance
and discusses the role of sentiments and behaviour in critical corporate finance decisions
such as capital budgeting decisions, dividend policy decisions, financing decisions, initial
public offerings (IPOs), mergers and acquisitions. It also explores the implications of
sentiments on corporate governance decisions, loyalty and agency conflicts. C 15
unravels the psychology and mechanism of financial planning in detail. It attempts to
provide an understanding of various behavioural biases that hinder the planning process
and other financial decisions. It discusses the history of financial planning in India and
abroad, its process and the role of financial literacy in it. It enables the readers to catego￾rise various investors into different types based on the behavioural biases they possess
and subsequent asset allocation recommendations for them. Finally, it delves into various
behavioural biases which may intervene in the hiring of a financial planner.
Part VII: The Way Forward
This part explores the future direction of behavioural finance. In this segment, a new
C 16 on Experimental Finance is introduced. The C builds the foundations
of understanding the importance of experiments in finance. It highlights the relevance of
experimental design in examining investor behaviour, market dynamics and decision￾making process. Further, it explains how well-designed experiments can uncover and
mitigate the biases. The C concludes with practical guidance on designing experi￾ments to test financial concepts.
xvi Preface
The final C 17 provides a brief introduction on how this field has progressed so
far, the challenges it faced, and the milestones achieved. It suggests that the scope of this
discipline is extremely wide with tremendous research potential at almost every level. It
takes the discussion forward by suggesting that the future research in this area will be
very specific, and goal based. For instance, these goals could be finding better investment
strategies, delving deeper into the mind of practitioners and role of behaviour in other
streams of finance. This C includes upcoming areas such as, value investing, interlinkage between behavioural finance and financial regulations, and forensic accounting.
This resource provides a comprehensive account of significant existing and upcoming
areas of behavioural finance. It has been developed keeping in mind the readers for whom
this is the first introduction to this discipline. Therefore, the language of the text is kept
simple and rigour to the minimum so that it is user-friendly. It mainly caters to the needs
of students of postgraduate management courses. It captures the majority of the relevant
topics of behavioural finance prescribed in the syllabi of various universities across India.
The resource is made interesting and informative with the help of a number of case insights,
figures, box items and real-life analogies. We hope that it will appeal to professional as
well as layman readers alike. We welcome any suggestions for further enrichment of the
resource.