Behavioral Finance - a Study of Investor's Emotion

Topics: Psychology, Financial markets, Economics Pages: 8 (2472 words) Published: February 16, 2011
Though Investment is a science deals with the study of capital market and then plan accordingly yet the study of investor's emotion has a major role to play with. It is not sufficient to analyze Efficient Market Hypothesis and its drawbacks rather one has to go for a behavioral explanation of investor's irrationality in a consistent and correlated manner. Thus comes Behavioral Finance, the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on market, into existence. In this study I have tried to analyze the concept of behavioral finance along with its four theories to explain the behavioral aspect of investors. This paper also focuses on its limitations. INTRODUCTION:

If we always assume that financial markets are efficient and investors are rational then why there are so many studies about investor's psychology? Investment managers always want to make money for themselves and for their clients. That is the reason they care about the "psychology" factor of financial market as well as investors. The behavior of investors is not always rational, so investment managers do not forget how the psychology factor of a person plays a substantial role in behavior of financial market. But, modern finance theories have almost completely ignored the role of the complex motivational and cognitive factors that influence investor's (the best asset of a company) decision making. In today's buyer-market, we should face the truth that psychology systematically explores human judgment behavior and well being. It can teach us important facts about how humans differ from traditional economic assumption. LITERATURE SURVEY

Earlier economics was closely attached to psychology, which was amply displayed in the book "The Crowd: A study of the popular Mind" published in 1896 by Gustave le Ban. The book was one of the greatest and most influential books of social psychology ever written. But with the development of Neo-classical economics, it has been taught to us that –

1) People have rational preferences among outcomes that can be identified and associated with a value 2) Individuals maximize utility and times maximize profits and 3) People act independently on the basis of full and relevant information. At that time, expected-utility and discounted-utility models began to gain wide acceptance generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively. By this time psychology had largely disappeared from economic and finance discussions. A revolutionary paper in the development of the behavioral finance and economics was published in 1979. Two famous psychologists Kahneman and Iversky published their paper "Prospect theory - An Analysis of Decision under Risk" and where cognitive psychological techniques were used to explain a number of documented divergences of economic decision making from neo- classical theory. In 1985, Wenner F.M. De Bondt and Richard Thaler published, "Does the Stock Market Over-react?" This is another milestone in linking psychology with Financial-Market and form the start of Behavioral Finance. They discovered that people systematically over-react to unexpected and dramatic news events, results in substantial weak form inefficiencies in the stock market, which was both surprising and profound. In 1981, Iversky and Kahneman introduced "framing". They showed that psychological principles that govern the perception of decision problems and the evaluation of probabilities and outcomes produce predictable shifts of preference when the same problem is framed in different ways. Gradually a number of psychological effects and factors have been incorporated into behavioral finance only to strengthen the subject. DEFINITION:

This realization gave birth to Behavioral Finance, a study of the influence of Psychology on the behavior of practitioner and the subsequent effect on markets. Behavioral...
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