Behavioural Finance

Behavioural Finance is the study of psychology and sociology on the behaviour of the financial
practitioners and the subsequent effect on the markets. It is the bridge between finance and
psychology.

It helps to understand why people buy or sell stock without doing fundamental analysis and behave
irrationally in investment decisions.

It demonstrates how emotions and cognitive errors influence investors in their decision making.

It investigates the behavioural patterns of investors and tries to understand how these patterns
guide investment decisions.

It offers many useful insights for investment professionals and thus provides a framework for
evaluating active investment strategies.
 Heuristics
Heuristics are the mental shortcuts that the brain uses to produce decisions or judgements, for
example, trying to climb a fog shrouded hill by making every step an upward-step.

On a daily basis we use heuristics techniques in decision making, it is a way we process information.
What this means is, we take a simple approach to problem solving, that may not take into account
all variables, but will produce a quick and satisfactory result, but may not be 100% accurate.

Examples of this are: rules of thumb, making educated guesses, intuitive judgment, stereotyping,
trial and error, or simply applying common sense.

Heuristics help simplify our lives on a daily basis. They are ingrained and have evolved over
thousands of years. However, heuristics don’t work in all situations and can lead to systematic
deviations from logic, probability or rational choice.
 Biases
Biases are human tendencies that lead us to follow a particular quasi-logical path, or form a certain perspective
based on predetermined mental notions and beliefs.

Behavioural Biases can be divided into two primary categories:

Cognitive Biases – These are a result of incomplete information or the inability to analyse and synthesize
information correctly. Cognitive biases are generally easier to overcome through adequate education and training.

Emotional Biases – These are a result of spontaneous reactions that affect how individuals see information.
Emotional biases are deeply ingrained in the psychology of investors and are generally much harder to overcome.

Some common psychological biases plaguing investors include: representative bias, cognitive dissonance, home
bias, familiarity bias, mood and optimism, overconfidence bias, endowment effects, status quo bias, reference
point & anchoring, law of small numbers, mental accounting, disposition effects, attachment bias, changing risk
preference, media bias and internet information bias.
 Irrational Behaviour
Irrational behaviour is not logical or reasonable. It is cognition, thinking, talking or acting without
inclusion of rationality. Irrational behaviour is one of the most difficult behaviours to deal with. When
someone is being irrational, they don't listen to reason, logic, or even common sense. They are laser
focused to fulfil a need.

Irrational behaviours of individuals include taking offense or becoming angry about a situation that
has not yet occurred, expressing emotions exaggeratedly (such as crying hysterically), maintaining
unrealistic expectations, engaging in irresponsible conduct such as problem intoxication,
disorganization, or extravagance, and falling victim to confidence tricks. People with a mental
illness like schizophrenia may exhibit irrational paranoia.

In investing, irrational exuberance is unsustainable investor enthusiasm that drives asset prices up
to levels that aren't supported by fundamentals, which lead to creation of a bubble.
 Prospect
Theory
Prospect Theory deals with the
irrational way we process
information, valuing gains and
losses differently (with losses
having a more profound effect on
our happiness than gains) and the
subsequent decisions we take.
Conclusion:
Loss does hurt, but get some
perspective. Enjoy the wins too!
Confirmation
Bias
Prospect
Theory
Confirmation Bias is our tendency
to try and find information that
supports an initial thought or
perception we have. We tend not to
go after information that may
challenge the idea.
Conclusion:
Never be afraid to challenge
yourself; better still get someone
else to challenge you.
Overreaction
Overreaction is an emotional
response to news about a security
that is generally led either by greed
or fear and pushes the price
artificially high or low. Thus, the
price does not reflect its fair value.
Conclusion:
Don’t overreact. Consider all
information in a balanced manner
and act accordingly.
 Mental
Accounting
Mental Accounting is when we assign
our money into “pots” depending on
where it came from and what we are
going to spend it on, we may have a
holiday pot or bonus money pot whilst
having a large credit card debt.
Conclusion:
Money is money, no matter where it
comes from or what you use it for;
always assign it the same value.
Herd
Behaviour
Prospect
Theory
Herd Behaviour is the tendency for
individuals to copy the actions of a
larger group. Individually, however,
most people would not necessarily
make the same choice.
Conclusion:
There is comfort in a crowd, but
ask yourself, would you rationally
make the same decision?
Gambler's
Fallacy
Gambler’s Fallacy is our misunderstanding
that random past events can have an effect
on future events. A single coin
toss always has a 50/50 chance of landing
on heads – even if there have been a series
of 10 tails tossed just before.
Conclusion:
Don’t make decisions based on
misunderstanding, look at the fundamentals
and make an informed decision.
Thank You!

Submitted By:
Parang Mehta
BBA MBA 2014
20142043
Jindal Global Business
School