Behavioural Finance

Topics: Decision making, Decision theory, Risk Pages: 7 (1954 words) Published: October 14, 2010
ROLE OF BEHAVIOURAL FINANCE IN INVESTMENT DECISIONS M. KANNADHASAN, MBA, MFT, M.Phil, Faculty, BIM, Trichy Introduction Decision-making is a complex activity. Decisions can never be made in a vacuum 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 decisionmaking 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. This needs better insight, and understanding of human nature in the existing global perspective, plus development of fine skills and ability to get best out of investments. In addition, investors’ have to develop positive vision, foresight, perseverance and drive. Every investor differ from others in all aspects due to various factors like demographic factors which includes socio-economic background, educational attainment level, age, race and sex. The most crucial challenge faced by the investors is in the area of investment decisions. An optimum investment decision plays an active role and is a significant consideration. In designing the investment portfolio, the investors should consider their financial goals, risk tolerance level, and other constraints. In addition to that, they have to predict the output mean- variance optimization. This process is better suited for institutional investors; it often fails for individuals, who are susceptible to behavioural biases.


In the present scenario, behavioural finance is becoming an integral part of the decision-making process, because it heavily influences investors’ performance. They can improve their performance by recognising the biases and errors of judgement to which all of us are prone. Understanding the behavioural finance will help the investors to select a better investment instrument and they can avoid repeating the expensive errors in future. The pertinent issues of this analytical study are how to minimise or eliminate the psychological biases in investment decision process.

Emergence 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 Slovic’s2 paper on individual’s misperceptions about risk and Amos Tversky and Daniel Kahneman’s papers on heuristic driven decision biases3 and decision frames4 played a...

References: 1. Jose Mathews (2005), “A situation-based Decision-making process,” The ICFAI Journal of Organisation Behaviour, July, Vol. IV, No.3, 19-25. 2. Slovic, P. (1972). ‘Psychological study of human judgement: Implications for investment decision making’, Journal of Finance, 27:779-801. 3. Tversky, A. and Kahneman, D. (1974). ‘Judgement under uncertainty: Heuristics and biases’, Science (185):1124-1131. 4. Kahneman, D. and Tversky, A. (1979). ‘Prospect theory:An analysis of decision making under risk’, Econometrica, 47(2):263-291. 5. Lintner, G. (1998). ‘Behavioral finance: Why investors make bad decisions’, The Planner, 13(1):7-8. 6. Olsen, R. (1998). ‘Behavioral finance and its implications for stock price volatility’, Financial Analysts Journal, 54(2):10-18. 7. Tony Brabazon , (2000). ‘ Behavioural Finance: A new sunrise or a false dawn?’, coil summer School 2000, Univesity of Limerick, pp 1-7 8. Debont, Werner, 1998, ‘ A portrait of the individual investor’ European Economic Review 42; pp831-834 9. Kahneman, D and Tversky, A., (1979), ‘ Prospect theory : An analysis of decision making under risk’, Econometrica, 4(2): pp 263-291 10. Venkatesh. B, (2002),’ what is Loss Aversion?’ Business Line, Sunday, December -01. 11. Ulrich Schmidta, and Horst Zankb, 2002, ‘What is Loss Aversion?’, available at 12. Richard J Thaler, (1999), ‘Mental Accounting Matters’ , Journal of Behavioural Decision making, 12, pp 183-206 13. Thaler,R. and Shefrin,H. (1981), ‘ An economic theory of self control’, Journal of Political Economy, 89 (2), pp 392-410 14. Shefrin, H, (2000),’Beyond Greed and Fear: understanding behavioural finance and the psychology of investing’, Harvard Business School Press, Boston, USA.
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