Behavioural Finance: Meaning and Applications | Financial Management

In this article we will discuss about:- 1. Definition of Behavioural Finance 2. Meaning of Behavioural Finance 3. Applications 4. Anomalies in Capital Markets.

Definition of Behavioural Finance:

Behavioural finance, with its roots in the psychological study of human decision-making, is a relatively new and evolving subject in the field of finance. In brief, behavioural finance is the study of investors’ psychology while making investment decisions. Being a relatively new subject, not much prodigious research literature is available in this subject.

However, some research studies have revealed that psychological biases such as emotions, fear, over- confidence, greed, and risk aversion influence investors’ behaviour that, in turn, influences stock markets. As such, there is a need for studying and understanding behavioural finance to exploit investors’ psychology for profits.

Behavioural finance is the study of investors’ psychology while making financial/investment decisions. Sewell (2001) has defined behavioural finance as “the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets”. According to Shefrin (1999), “behavioural finance is the application of psychology to financial behaviour – the behaviour of investment practitioners.”

Some of the definitions of Behavioural finance can be summarized:

1. Lintner G. (1998) has defined behavioural finance as being study of human interprets and acts on information to make informed investment decisions.

2. Olsen R. (1998) asserts that behavioural finance seeks to understand and predict systematic financial market implications of psychological decision process.

3. Shefrin (1999), “Behavioural finance is rapidly growing area that deals with the influence of psychology on the behaviour of financial practitioner”.

4. Belsky and Gilovich (1999) have referred to behavioural finance as behavioural economics and further defined behavioural economics as combining the twin discipline of psychology and economics to explain why and how people make seemingly irrational or illogical decisions when they save, invest, spend and borrow money.

5. W. Forbes (2009) defined behavioural finance as a science regarding how psychology influences financial market. This view emphasizes that the individuals are affected by psychological factors like cognitive biases in their decision-making, rather than being rational and wealth maximizing.

6. M. Sewell (2007) has stated that behavioural finance challenges the theory of market efficiency by providing insights into why and how market can be inefficient due to irrationality in human behaviour.

7. M. Schindler (2007) has given certain examples while defining behavioural finance:

(a) Investors’ biases when making decisions and thus letting their choices to be influenced by optimism, overconfidence, conservatism.

(b) Experience and heuristics help in making complex decisions.

(c) The mind processes available information, matching it with the decision’s maker own frame of reference, thus letting the framing by the decision the maker impact the decision.

Thus behavioural finance is defined as the field of finance that proposes psychological based theories to explain stock market anomalies. Within the behavioural finance it is assumed that the information structure and the characteristics of market participants systematically influence individual’s investment decisions as well as market outcomes.

Meaning of Behavioural Finance:

Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on market. According to behavioural finance, investors’ market behaviour derives from psychological principles of decision-making to explain why people buy or sell stock. Behavioural finance focuses upon how investor interprets and acts on information to take various investment decisions.

In addition behavioural finance also places emphasis on investor’s behaviour leading to various market anomalies. Behavioural Finance (BF) is the study of investors’ psychology while making financial decisions. Investors fall prey to their own and sometimes others’ mistakes due to use of emotions in financial decision-making. For many financial advisors BF is still an unfamiliar and unused subject.

There are some financial advisors, however, who have taken the time to read and learn about BF and use it in practice with good results. These advisors realize that being successful is just as much about building great relationships with clients as it is about delivering investment performance.

And they have observed that BF can provide tools that can help them ‘get inside’ the head of their clients in order to build mutually beneficial relationships. Understanding how clients actually think and behave is a key ingredient in the recipe for success in acquiring and retaining clients. As such, BF is becoming a powerful force in the financial advisory field.

BF tries to understand how people forget fundamentals and take investment decisions based on emotions. For decades, economists have argued about the rational behaviour of investors. Now psychologists are weighing in, and they are finding that human beings often do not act that way.

“Psychology has a story to tell about investing, and it is different from the one economics tells,” says Princeton Psychologist Daniel Kahneman. BF is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets.

Research in this area is emerging from the academia and the results are being taken into account in the field of money management. Finance practitioners use rules of thumb or heuristics to process data.

For example, people use past performance as the best predictor for future performance and often invest in the mutual funds with the best five year track records. These rules are likely to be faulty and generally lead to poor decisions. Relying on such heuristics is called ‘Heuristic Bias’.

During bull phases, markets are full of momentum investing which is just another way of saying “buy high & sell higher”. Ultimately momentum investors are looking for the greater fool who will pay more for the share than they did. It is really a form of gambling. This kind of gambling makes investors particularly susceptible to torpedo stocks.

Applications of Behavioural Finance:

Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) are based on rational and logical theories. These theories assume that people, for the most part, behave rationally and predictably. For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational theories did a respectable and commendable job of predicting and explaining certain events.

However, as time went on, academics in both finance and economics started to find anomalies and behaviours that could not be explained by the theories available at the time. While these theories could explain certain ‘idealized’ events, the real world proved to be a messy place in which market participants often behaved very unpredictably.

People are not always rational and markets are not always efficient. Behavioural finance explains why individuals do not always make the decisions they are expected to make and why markets do not reliably behave as they are expected to behave.

Recent research shows that the average investors make decisions based on emotion, not logic; most investors buy high on speculation and sell low in panic mode. Behavioural finance is a new academic discipline which seeks to apply the insights of the psychologists to understand the behaviour of both investors and financial markets. It helps us to avoid emotion-driven speculation leading to losses, and thus devises an appropriate wealth management strategy.

If behavioural finance were to be helpful to the majority of financial advisors in creating better investment portfolios, the three key challenges are required to be tackled:

First, advisors needed a guidebook to teach them the basics of behavioural biases and how to diagnose them in clients.

Second, even if advisors could diagnose client biases, they needed to know what to do with that information. For example, given a certain set of behaviours, should they attempt to change behaviour of the client to match the allocation that is right for the client, or should they change the allocation to match the client’s behaviour.

Third, the industry needed a common BF language. Behavioural biases, as earlier articulated, were not user friendly because there was not a widely accepted set of terms for describing and communicating these biases to other advisors or to clients.

To understand the behavioural biases, the prerequisite is an understanding of various personality dimensions which have implications for the investors’ behaviour. The purpose of behavioural finance is, given the irrational investors’ behaviour, to create better investment portfolio for financial advisors.

In doing so, certain key challenges relating to investment decisions need to be tackled. First and foremost, the investment advisors need a comprehensive guidebook to make them understand basics of behavioural biases and how to properly diagnose them in their clients.

Anomalies in Capital Markets:

Some of the main anomalies that have been identified in the stock market behaviour are as follows: 

1. Low PE Effect:

Some evidence indicates that low PE stocks outperform higher PE stocks of similar risk. Studies show that stocks of companies with low P/E ratio earned a premium for investors. An investor who held the low P/E ratio portfolio earned higher returns than an investor who held the entire sample stocks. These results also contradict the EMH.

2. Low-Priced Stocks:

Many people believe that the price of every stock has an optimum trading range.

3. Small Firm Effect:

Small-firm effect is also known as the ‘size-effect’. Studies have revealed that excess returns would have been earned by holding stocks of low capitalization companies. If the market were efficient, one would expect the prices of stocks of these companies to go up to a level where the risk adjusted returns to future investors would be normal. But this did not happen.

4. Neglected Firm Effect:

Neglected firms seem to offer superior returns with surprising regularity.

5. Over/Under Reaction of Stock Prices to Earnings Announcements:

Studies present evidence that is consistent with stock prices over-reacting to current changes in earnings. They report positive (negative) estimated abnormal stock returns for portfolios that previously generated inferior (superior) stock price and earning performance. This could be construed as the prior period stock price behaviour over-reacting to earnings developments.

6. January Effect:

Studies have documented evidence of higher mean returns in January as compared to other months.

7. Weekend Effect (Monday Effect):

Studies have found that there is a tendency for returns to be negative on Mondays whereas they are positive on the other days of the week, with Friday being the best of all.

8. Other Seasonal Effects:

Holiday and turn of the month effects have been well-documented over time and across countries. Studies show that US stock returns are significantly higher at the turn of the month, defined as the last and first three trading days of the month.

9. Persistence of Technical Analysis:

If the EMH is true, technical analysis should be useless. Each year, however, an immense amount of literature based in varying degrees on the subject is printed.

10. Standard & Poor’s Index Effect:

Studies find a surprising increase in share prices (up to 3 percent) on the announcement of a stock’s inclusion into the S&P 500 index. Since in an efficient market only information should change prices, the positive stock price reaction appears to be contrary to the EMH because there is no new information about the firm other than its inclusion in the index.

11. Weather:

Sunshine puts people in a good mood in temperate climates. People in good moods make more optimistic choices and judgments.

These phenomena have been rightly referred to as anomalies because they cannot be explained within the existing paradigm of EMH. It clearly suggests that information alone is not moving the prices. These anomalies have led researchers to question the EMH and to investigate alternate modes of theorizing market behaviour.