In the modern finance theory , behavioral finance is a new paradigm , which seeks to appreciate and expect systematic financial market influence of psychological decision making ( Olsen R A, 1998). In the recent studies irrationality in the decision making was revealed , based on certain cognitive limitations. The present chapter is divided into two aspects
According to traditional models in finance and economics, human beings are rational while taking their decision. However the recent studies explain that decision making is based on certain cognitive limitations. As the information’s are overloaded, we will be applying certain short cuts or heuristics in order to take a decision. The most important heuristics in the representativeness
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Essentially, behavioral finance attempts to explain the what, why, and how of finance and investment, from a human perspective” (See figure 2). (Shefrin, 2000) however, mentioned the difference between cognitive and affective (emotional) factors: “cognitive aspects concern the way people organize their information, while the emotional aspects deal with the way people feel as they register information” . Figure 2 The Underpinning of Behavioral Finance
Source: (Victor Riccardi & Helen K Simon, 2000)
PSYCHOGRAPHIC MODELS
Models are designed to classify people according to certain characteristics, tendencies or behavior.. Psychographic classifications are particularly relevant with regards to individual strategy and risk tolerance. The useful models of investors psychographic were Barnewall (1987) and Bailard, Biehl and Kaiser (1986).
Barnewall Two way model (Barnewall, 1987)
This is one of the most previous and most prevalent investor model based on the work of Marilyn MacGruder. Barnewall distinguished the investors into two types : passive investors and active investors.
Passive investors are those investors those who have become wealthy passively –by inheritance or by risking the capital of others rather than their own capital. They have a greater need for security than they have tolerance for risk. Occupational groups such as corporate executives, lawyers, Chartered Accountants,
So according to the Efficient Market Theory it is impossible for any investor to “beat the market” that is earn more profit or get more return than what the market is actually offering. Therefore the investor can only earn greater profits on his investment if the investment portfolio includes a high proportion of risky investments that is those with higher standard deviations and betas but with a good capability of yielding high returns as well (Stephens, C.R., 2010).
Kahneman’s article is an analysis of intuitive thinking and how it guides our decision-making. Although primarily aimed at the field of psychology, it is an interdisciplinary article with applications in economic theorising. Kahneman attempts to differentiate between two systems of thought, one of intuition (system 1) and one of reasoning (system 2), and argues that many judgements and choices are made intuitively, rather than with reason (a slower and more deliberate process). Intuitive decision making, which encompasses heuristics, although generally more efficient and rapid, makes the agent potentially subject to errors due to framing effects or violations of dominance. The analysis of the studies and theoretical situations also provides criticism of the commonly held model of the rational agent within economics. The article also further conceptualises Kahneman’s theory, the Prospect Theory (Kahneman & Tversky, 1979), which has descriptive applications of people’s choice in decision-making situations involving risk and known probability of outcomes. These situations are typically unexplained by the more normative rational agent model.
Behavioral Finance is the new emerging science that explains the irrational behaviour of investors. Behavioral Finance unwind the usual assumption of traditional finance by incorporating systematic, observable and human departures from rationality into models of financial markets and behaviour. It helps us to understand the actual the behaviour of investors versus theories of investors’ behaviour.
Behavioural economics is the study of the effects that psychology has on the decision making of the economy. This tends to be the way that people think and feel when they are spending money on a certain good or service. The great economist Adam Smith was the first follower of this idea through his book “The theory of moral sentiments” which dates back to 1759. However, it took over 100 years to get a more clarified meaning of how big of a role the psychology of a buyer plays in economics. In behavioural economics there are seven basic principles which all contribute to the decision making process. Behavioural economics can explain how people will react to different situations such as times when there are no economic problems and times when
The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to
Closed-end fund puzzles summarize four abnormal phenomenons which occur in funds price. Lee, Shleifer and Thaler (1991) state that three elements (agency costs, tax liabilities and illiquidity of assets) may quote for explanations of these puzzles in traditional finance. Nevertheless, they advocate that analyzing puzzles base on behaviour finance, such as noise trader risk theory and individual investor sentiment theory, can expound puzzles better.
This is a brief overview of the different vehicles available to utilize when investing. The financial market is where investors trade commodities, stocks, mutual funds, stocks, bonds, and traditional bank accounts which all can accrue interest. The different options provide very different options and different levels of risk. One can invest in something on the conservative side, moderate, or be aggressive. Depending on the type of investor you are depends on the type of investment that meets one’s needs. The word diversification is a vital word which, investing in multiple different stocks, and getting rid of unwanted risk. (Jones 2008). In addition, not being diversified means you are incurring a high risk and, thereby higher volatility. Further, if an investor puts funds into one particular stock or investment, and it loses its entire value, then this investment incurred a significant loss. Whereas, a savvy investor will have been diversified. For example, investing 50k in investing in the stock market, bonds, mutual funds and purchase some real estate, this is the exact meaning of
For many, the markets are a place that creates confusion and uncertainty. This is because these changes will have an adverse impact on their interpretations of different events. The results are that the indices will become increasingly volatile. These factors mean that the emotions of fear and greed will drive these movements. To fully understand these elements requires focusing on the causative variables, the relationship between the different indicators, interpreting the coefficients / providing an analysis of the correlation coefficient values and a summary of what was discovered. Together, these elements will highlight the way these transformations are occurring and the long term impacts they will have on investors' perceptions of underlying events. (Weinstein, 1988) (Graham, 1976)
Collecting, analysing and interpreting financial data has always been the important objectives of the members in the financial markets, ranging from governments, big time billionaire corporations to even the small individual financial analysts. This is because by gaining a keen understanding of the current financial situation in the market, another objective can be pursued, which is forecasting. One of such forecast is regarding investor expectations in the market. Investors often refer to individuals who commits money to investment products with the expectation of financial return. Since most investors become the main pillars of finance for corporations, by gaining an understanding of
In today’s world, many decisions are executed based on the financial market. As a result, it is paramount that people grasp the way markets behave and learn the best way to respond. Yet, so few of them choose to pursue this endeavor. Such willful ignorance has allowed the field to be permeated by charlatans who spread misinformation. The desire for truth about a very important aspect of our lives drove me to start searching for objective information about financial markets. Finance is the discipline that incorporates elements from some of my favorite subjects: computer science, mathematics, and economics.
Many finance specialist use conventional finance to assist them with determining and analyzing stock performance. According to Albert Phung’s article on Investopedia titled “Behavioral Finance Background” many models have been created from conventional finance such as the Capital Asset Pricing Model and the Efficient Market Hypothesis. This section describes why behavioral finance should have a more active role in finance. This article states “academics in both finance and economics started to find anomalies and behaviors that couldn 't be explained by theories available at the time. While these theories could explain certain ‘idealized’ events, the real world proved to be a very messy place in which market participants often behaved very unpredictably” (Phung, 2014). Conventional and behavioral finance is compared to one another throughout this article. Phung states that behavioral finance is designed to explain our actions, while conventional finance is designed to explain the actions of the “wealth maximizers”, otherwise known as the
Herein, the paper offers a practical example of an investment process or activity. Using the above investment procedures, the paper rigorously shows how investors
In conclusion, the active investing is more flexible than passive investing because active investing does not have to follow a specific index like S&P 500. According to Elton and Gruber (1997), the choice of the portfolio manager to choose for active portfolio is mainly based on his or her perception on the degree of market efficiency. There is no doubt that active investing is superior to passive portfolio when market mis-priced the asset. But active
This research tries to address the problem from an investor’s point of view, which kind
Our target customers will particularly be the small and medium investors who are unable to avail such services as most of the financial and advisory firms mostly deal with the big ticket investors and thus the small investors have no choice but to invest their assets in passive funds in investment management companies or mutual funds companies which are subjected to index and fund manager’s performance and thus may not bring expected returns. However recent evidence of systematic departures of asset prices in the from equilibrium values, as envisaged under the market efficiency, has renewed interest in ‘active’ fund management and investment advisory services and which entails that optimal selection of stocks, and the timing of