International Journal of Enterprise Innovation Management Studies(IJEIMS)

Vol2. No2. July-Dec 2011 ISSN: 0976-2698

www.ijcns.com

OVERVIEW OF BEHAVIOURAL FINANCE

M.Hemanathan
Research Scholar Bharathiar University ,Coimbatore.
Asst. Prof., of Management Studies, Arulmigu Meenakshi Amman College of Engineering, Vadamavandal,
Tiruvannamalai District.
mhemanathanmba@gmail.com
Dr.M.Anbalagan
Professor & Head, Department of Commerce and Business Administration, Voorhees College, Vellore.
---------------------------------------------------------------------------------------------------------------------------------------------------
ABSTRACT
---------------------------------------------------------------------------------------------------------------------------
An introduction to behavioural finance, including a review of the major works and a summary of important
heuristics. This study aimed to provide a brief introduction to behavioral finance and this essay is motivated by
the new tendencies of research in future. It provides good informations to the rational investors to functioning
in efficient markets.

----------------------------------------------------------------------------------------------------------------------------
Keywords: Behavioral Finance; Decision-making process; Investors; Stock market;
---------------------------------------------------------------------------------------------------------------------------------------------------
1 INTRODUCTION

Behavioural finance is the study of the incorruptibility of psychology on the behaviour of financial
practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain
why and how markets might be inefficient. For more in sequence on behavioural finance, see Sewell (2001).
Decision-making is a complex activity. Decisions can never be made in a emptiness by relying on the personal
resources and complex models, which do not take into consideration the situation. Analysis of the variables of
the problem in which it occurs is mediated by the cognitive psychology of the manager. A situation based on
decision-making activity encompasses not only the specific problem faced by the individual but also extends to
the environment. Decision-making can be defined as the process of choosing a particular alternative from a
number of alternatives. It is an activity that follows after proper evaluation of all the alternatives1. They need to
update themselves in multidimensional fields so that they can accomplish the desired results/ goals in the
competitive business environment.

2 REVIEW OF LITRATURE

Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and
most inuential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the
Stock Market. He based the book `upon the belief that the movements of prices on the exchanges are dependent
to a very considerable degree on the mental attitude of the investing and trading public'.In 1956 the US
psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance
(Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will
produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will
strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks
considered as a proportion of total assets. Tversky and Kahneman (1973) introduced the availability heuristic: `a
judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by

112
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

availability, i.e. by the ease with which relevant instances come to mind.' The reliance on the availability
heuristic leads to systematic biases. In 1974, two brilliant psychologists, Amos Tversky and Daniel Kahneman,
described three heuristics that are employed when making judgments under uncertainty (Tversky and Kahneman
1974):

Objectives of the study:

To study or understand the new applied science of good decision making.

To study and managing behavioural decisions and preferences of the investors.

To give the suitable behavioural oriented explanations for the financial disaster.

To study the explore ways of the decision makers and companies have implemented behavioural finance

advance and how to develop your suitable policy.

3. APPEARANCE OF BEHAVIOURAL FINANCE

The principal objective of an investment is to make money. In the early years, investment was based on
performance, forecasting, market timing and so on. This produced very ordinary results, which meant that
investors were showered with very ordinary futures, and little peace of mind. There was also a huge gap between
available returns and actually received returns which forced them to search for the reasons. In the examining
process, they identified that it is caused by fundamental mistakes in the decision-making process. In other words,
they make irrational investment decisions. In recognizing these mistakes and means to avoid them, to transform
the quality of investment decisions and results, they realized the impact of psychology in investment decisions.
Several years ago, the researchers began to study the field of Behavioral Finance to understand the psychological
processes driving these mistakes. Thus, Behavioural finance is not a new subject in the field of finance and is
very popular in stock markets across the world for investment decisions.

Many investors have, for long considered that psychology plays a key role in determining the behaviour
of markets. However, it is only in recent times that a series of concerted formal studies have been undertaken in
this area. Paul Slovics2 paper on individuals misperceptions about risk and Amos Tversky and Daniel
Kahnemans papers on heuristic driven decision biases3 and decision frames4 played a seminal role. The results
of these studies were at variance with the rational, self-interested decision-maker posited by traditional finance
and economics theory.

4.BEHAVIOURAL FINANCE PHILOSOPHY AND ITS IMPLICATIONS

Under the traditional financial theory, the decisions makers are rational. In contrast, modern theory suggests that
Investors financial decision-making are not driven by due considerations. The decisions are taken by them are
also often inconsistent. Put in another way, human decisions are subject to several cognitive illusions. These are
grouped into two and have been depicted.

113
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

6. HEIRISTIC DECISION PROCESS

The decision process by which the investors find things out for themselves, usually by trial and error, lead to
the development of rules of thumb. In other words, it refers to rules of thumb which humans use to made
decisions in complex, uncertain environments7. The reality, the investors decision making process are not
strictly rational one. Thought the investors have collected the relevant information and objectively evaluated, in
which the mental and emotional factors are involved. It is very difficult to separate. Sometimes it may be good,
but many times it may result in poorer decision outcomes. It includes:

1. delegative ness:

The investors recent success; tend to continue into the future also. The tendency of decisions of the investors to
make based on past experiences is known as stereotype. Debont (1998)8 concluded that analyses are biased in
the direction of recent success or failure in their earnings forecasts, the characteristic of stereotype decisions

2. boldness:

There are several dimensions to confidence. It can give more courage, and is often viewed as a key to success.
Although confidence is often encouraged and celebrated, it is not the only factor to success. The investors who
are cautious and analytical can achieve success and others have to withdraw. Yet, confidence, especially self-
confidence, is often viewed as a positive trait. Sometimes, the investors overestimate their predictive skills or
assuming more knowledge then they have. Many times it leads excessive trading.

3. secureness:

It describes the common human tendency to rely too heavily, or anchor on one trait or piece of information
when making decisions. When presented with new information, the investors tend to be slow to change or the
value scale is fixed or anchored by recent observations. They are expecting the trend of earning is to remain with
historical trend, which may lead to possible under reactions to trend changes.

4. Gamblers fallacy:

It arises when the investors inappropriately predict that tend will reverse. It may result in anticipation of good or
poor end.

5.Accessibility bias:

The investors place undue weight for making decisions on the most available information. This happens quite
commonly. It leads less return and sometimes poor results also.

panorama theory

This theory is developed by Kahneman and Tversky9. The second groups of illusions which may impact the
decision process are grouped in prospect theory. He discussed several states of mind which may influence an
investors decision making process.

114
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

1. Loss aversion:

Loss aversion is an important psychological concept which receives increasing attention in economic analysis.
The investor is a risk-seeker when faced with the prospect of losses, but is risk-averse when faced with the
prospects of enjoying gains. This phenomenon is called loss aversion10. Ulrich Schmidta, and Horst Zankb11
discussed the loss aversion theory with risk aversion and he aceepted the Kahneman and Tversky views.

2. Regret Aversion:

It arises from the investors desire to avoid pain of regret arising from a poor investment decision. This aversion
encourages investors to hold poorly performing shares as avoiding their sale also avoids the recognition of the
associated loss and bad investment decision. Regret aversion creates a tax inefficient investment strategy
because investors can reduce their taxable income by realizing capital losses.

3. Mental Accounting: Mental accounting is the set of cognitive operations used by the investors to organise,
evaluate and keep track of investment activities. Three components of mental accounting receive the most
attention. This first captures how outcomes are perceived and experienced, and how decisions are made and
subsequently evaluated. A second component of mental accounting involves the assignment of activities to
specific accounts. Both the sources and uses of funds are labelled in real as well as in mental accounting
systems.The third component of mental accounting concerns the frequency with which accounts are evaluated
and 'choice bracketing'. Accounts can be balanced daily, weekly, yearly, and so on, and can be defined narrowly
or broadly. Each of the components of mental accounting violates the economic principle of fungibility. As a
result, mental accounting influences choice, that is, it matters12.

4. Self Control:

It requires for all the investors to avoid the losses and protect the investments. As noted by Thaler and shefrin13
investros are subject to temptation and they look for tools to improve self control. By mentally separating their
financial resources into capital and available for expenditure pools, investors can control their urge to over
consume.

6.Conclusions

Though the above examples of illusions are widely observed, behavioural finance does not claim that
all the investors will suffer from the same illusion simultaneously. The susceptibility of an investor to a
particular illusion is likely to be a function of several variables. For example, there is suggestive evidence that
the experience of the investor has an explanatory role in his regard with less experienced investors being prone
to extrapolation (representativeness) while more experienced investors commit gambler fallacy14.similarly,
behavioural factors play a vital role in the decision making process of

the investors. Hence the investors has to take necessary steps to minimise or avoid illusions for influencing in
their decision making process, investment decisions in particular.

115
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

References

BANERJEE, Abhijit V., 1992. A Simple Model of Herd Behavior. The Quarterly Journal of
Economics, 107(3), 797{817. BARBER, Brad M., and Terrance ODEAN, 2001. Boys Will be Boys:
Gender, Overcon_dence, and Common Stock Investment. The Quarterly Journal of Economics, 116(1),
261{292.
BARBERIS, Nicholas, and Ming HUANG, 2001. Mental Accounting, Loss Aversion, and Individual
Stock Returns. The Journal of Finance, 56(4), 1247{1292.
BARBERIS, Nicholas, Ming HUANG, and Tano SANTOS, 2001. Prospect Theory and Asset Prices.
The Quarterly Journal of Economics, 116(1), 1{53.
BARBERIS, Nicholas, Andrei SHLEIFER, and Robert VISHNY, 1998. A Model of Investor
Sentiment. Journal of Financial Economics, 49(3), 307{343.
BARBERIS, Nicholas C., and Richard H. THALER, 2003. A Survey of Behavioral Finance. In: George
M. CONSTANTINIDES, Milton HARRIS, and Ren_e M. STULZ, eds. Handbook of the Economics of
Finance: Volume 1B, Financial Markets and Asset Pricing. Elsevier North Holland, Chapter 18, pp.
1053{1128.
BASU, Sudipta, 1997. The Conservatism Principle and the Asymmetric Timeliness of Earnings.
Journal of Accounting and Economics, 24(1), 3{37. BENARTZI, Shlomo, and Richard H. THALER,
1995. Myopic Loss Aversion and the Equity Premium Puzzle. The Quarterly Journal of Economics,
110(1), 73{92.
BERNOULLI, Daniel, 1738. Specimen theoriae novae de mensura sortis. Co- mentarii Academiae
Scientiarum Imperialis Petropolitanae, 5, 175{192.
BERNOULLI, Daniel, 1954. Exposition of a New Theory on the Measurement of Risk. Econometrica,
22(1), 23{36. English translation of Bernoulli (1738) by Louise Sommer.
.BIKHCHANDANI, Sushil, David HIRSHLEIFER, and Ivo WELCH, 1998. Learning from the
Behavior of Others: Conformity, Fads, and Informational Cascades. The Journal of Economic
Perspectives, 12(3), 151{170. BIRNBAUM, Michael H., 2008. New Paradoxes of Risky Decision
Making. Psychological Review, 115(2), 463{501.
CAMERER, Colin, and Dan LOVALLO, 1999. Overcon_dence and Excess Entry: An Experimental
Approach. The American Economic Review, 89(1), 306{318.9
CHAN, Louis K. C., Narasimhan JEGADEESH, and Josef LAKONISHOK, 1996. Momentum
Strategies. The Journal of Finance, 51(5), 1681{1713.
DANIEL, Kent, David HIRSHLEIFER, and Avanidhar SUBRAHMANYAM, 1998. Investor
Psychology and Security Market Under- and Overreactions. The Journal of Finance, 53(6), 1839{1885.
De Bondt, Werner F. M., and Richard THALER, 1985. Does the Stock Market Overreact? The Journal
of Finance, 40(3), 793{805. De Bondt, Werner F. M., and Richard H. THALER, 1987. Further
Evidence on Investor Overreaction and Stock Market Seasonality. The Journal of Finance, 42(3),
557{581. FAMA, Eugene F., 1998. Market E_ciency, Long-Term Returns, and Behavioral Finance.

116
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

Journal of Financial Economics, 49(3), 283{306. FERNANDEZ, Raquel, and Dani RODRIK, 1991.
Resistance to Reform: Status Quo Bias in the Presence of Individual-Speci_c Uncertainty. The
American Economic Review, 81(5), 1146{1155.
FESTINGER, Leon, Henry W. RIECKEN, and Stanley SCHACHTER, 1956.When Prophecy Fails.
Minneapolis: University of Minnesota Press.
FINUCANE, Melissa L., et al., 2000. The A_ect Heuristic in Judgments of Risks and Bene_ts. Journal
of Behavioral Decision Making, 13(1), 1{17.
GHASHGHAIE, S., et al., 1996. Turbulent Cascades in Foreign Exchange Markets. Nature, 381(6585),
767{770. GIGERENZER, Gerd, and Reinhard SELTEN, eds., 2001. Bounded Rationality:.
The Adaptive Toolbox. DahlemWorkshop Reports. Cambridge, MA: The MIT Press. GIGERENZER,
Gerd, Peter M. TODD, and the ABC Research Group, 1999. Simple Heuristics That Make Us Smart.
Oxford: Oxford University Press.
GILOVICH, Thomas, 1991. How We Know What Isn't So: The Fallibility of Human Reason in
Everyday Life. New York: The Free Press.
GILOVICH, Thomas, and Dale GRIFFIN, 2002. Introduction { Heuristics and Biases: Then and Now.
In: Thomas GILOVICH, Dale GRIFFIN, and Daniel KAHNEMAN, eds. Heuristics and Biases: The
Psychology of Intuitive Judg- ment. Cambridge University Press, pp. 1{18.
GILOVICH, Thomas, Dale GRIFFIN, and Daniel KAHNEMAN, eds., 2002. Heuristics and Biases:
The Psychology of Intuitive Judgment. Cambridge: Cambridge University Press.
GRINBLATT, Mark, and Matti KELOHARJU, 2001. What Makes Investors Trade? The Journal of
Finance, 56(2), 589{616. 10
GRINBLATT, Mark, Sheridan TITMAN, and Russ WERMERS, 1995. Momentum Investment
Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior. The American
Economic Review, 85(5), 1088{1105.
HARRISON, Glenn W., and E. Elisabet RUTSTR OM, 2009. Expected Utility Theory and Prospect
Theory: One Wedding and a Decent Funeral. Experi-mental Economics, 12(2), 133{158.
HOLT, Charles A., and Susan K. LAURY, 2002. Risk Aversion and Incentive E_ects. The American
Economic Review, 92(5), 1644{1655.
HONG, Harrison, Terence LIM, and Jeremy C. STEIN, 2000. Bad News Travels Slowly: Size, Analyst
Coverage, and the Pro_tability of Momentum Strategies. The Journal of Finance, 55(1), 265{295.
HONG, Harrison, and Jeremy C. STEIN, 1999. A Uni_ed Theory of Underreaction, Momentum
Trading, and Overreaction in Asset Markets. The Journal of Finance, 54(6), 2143{2184.
HUBERMAN, Gur, 2001. Familiarity Breeds Investment. The Review of Fi- nancial Studies, 14(3),
659{680.
KAHNEMAN, Daniel, Jack L. KNETSCH, and Richard H. THALER, 1990. Experimental Tests of the
Endowment E_ect and the Coase Theorem. Journal of Political Economy, 98(6), 1325{1348.
KAHNEMAN, Daniel, Jack L. KNETSCH, and Richard H. THALER, 1991. Anomalies: The
Endowment E_ect, Loss Aversion, and Status Quo Bias.

117
 International Journal of Enterprise Innovation Management Studies(IJEIMS)
Vol2. No2. July-Dec 2011 ISSN: 0976-2698
www.ijcns.com

Jose Mathews (2005), A situation-based Decision-making process, The ICFAI Journal of

Organisation Behaviour, July, Vol. IV, No.3, 19-25.
Slovic, P. (1972). Psychological study of human judgment: Implications for investment decision
making, Journal of Finance, 27:779-801.
Tversky, A. and Kahneman, D. (1974). Judgement under uncertainty: Heuristics and biases, Science
(185):1124-1131.
Kahneman, D. and Tversky, A. (1979). Prospect theory:An analysis of decision making under risk,
Econometrica, 47(2):263-291.
Lintner, G. (1998). Behavioral finance: Why investors make bad decisions, The Planner, 13(1):7-8.

118