Behavioral finance and investment decision making

*Neha, **Tanu

Abstract
Behavioral finance explores the psychological factors influencing investment
decisions. This review paper delves into the key principles of behavioral finance
and its impact on investment and its impact on investment decision-making. It
examines cognitive biases, emotional influences, and heuristics affecting investor
behavior. Through empirical evidence and case studies, it elucidates how these
behavioral aspects drive deviations from rational decision-making in financial
markets, impacting asset pricing and portfolio management strategies.
Understanding these behavioral patterns can aid investors, financial advisors, and
policymakers in making more informed and rational investment decisions.
Key words: finance, decision-making, investors, portfolio and policy makers
1. INTRODUCTION
Behavioral finance stands at the intersection of psychology and finance, offering a
profound understanding of how human behavior influences investment decisions.
Traditional financial theories often assume rationality in decision-making, but
behavior influence recognizes that human emotions, cognitive biases, and social
factors significantly impact investment choices. This field delves into the
deviations from rationality, exploring biases such as overconfidence, loss aversion,
and herding behavior that affect investors’ judgment. Understanding these
behavioral patterns is critical as it elucidates why markets aren’t always efficient
and why investors might make suboptimal choices.
This review paper aims to dissect the key concepts in behavioral finance, shedding
light on how psychological factors shape investment decisions. By examining
behavioral biases and their implications for investment strategies, this paper seeks
to provide insights into navigating the complex landscape of financial markets
while considering human behavior as a crucial determinant in investment decision-
making.
This introduction briefly introduces the concept of behavioral finance, highlights
its significance in understanding investment decisions, and adjustments and
expansions can be made as er the specific focus and direction of the paper.
2.Evaluation of behavioral finance

Behavioral finance provides a valuable lens through which to understand the intricacies of
human decision-making in financial contexts. By acknowledging and studying behavioral
biases, heuristics, and emotional influences, it offers a more nuanced perspective compared
to traditional finance theories. This approach contributes to explaining market anomalies
and investor behavior that can't be fully accounted for by rational models. However, while
behavioral finance enriches our comprehension of financial decision-making, it also poses
challenges in quantifying and integrating these insights into predictive models, requiring a
delicate balance between theory and practical application.

3.Traditional finance versus behavioral finance

3.1 Traditional approaches to Invester behavior
Traditional approaches to investor behavior often draw
Traditional approaches to Invester behavior often draw from various theories and
models within the field of finance and economics. Some key traditional approaches
include:
❖ Efficient Market Hypothesis (EMH): This theory suggests that financial
markets efficiently incorporate all available information into asset prices.
According to EMH, it’s impossible to consistently outperform the market
because stock prices reflect all relevant information.
❖ Modern Portfolio Theory (MPT): Developed by Harry Markowitz, MPT
emphasizes diversification to minimize risk while maximizing returns. It
suggests that by allocating investments across a diversified portfolio of
assets with different risk levels, investors can optimize their risk-return
tradeoff.
❖ Behavioral Finance: Traditional finance assumes rational behavior, but
behavioral finance considers psychological biases that influence investors. It
examines how emotions, cognitive errors, and heuristics impact decision-
making, leading to deviations from traditional financial models.
❖ Prospect Theory: Developed by Daniel Kahneman and Amos Tversky, this
theory explains how people make decisions under uncertainty. It suggests
that individuals tend to value gains and losses differently, often exhibiting
risk aversion when it comes to gains and risk-seeking behavior when facing
losses.
 ❖ Capital Asset Pricing Model (CAPM): CAPM estimates the expected return
of an asset based on its risk level in relation to the market as a whole. It
suggests that expected returns are proportional to the asset's beta, a measure
of its volatility compared to the market.
❖ Herd Behavior: Investors often follow the actions of the crowd instead of
conducting individual analysis. Herding behavior can lead to market bubbles
or crashes as individuals mimic others' actions without considering
fundamental factors.
❖ Risk Appetite and Risk Tolerance: Traditional approaches consider
investors' risk appetites and tolerance levels, assessing how much risk an
investor is willing to take and how much risk they can actually bear in their
investment portfolios.
❖ Technical and Fundamental Analysis: Traditional investors may rely on
technical analysis (studying past market data and trends) or fundamental
analysis (evaluating a company's financial health, management, industry
trends) to make investment decisions.
These traditional approaches offer frameworks and theories to understand and
predict investor behavior, but they have limitations. For instance, behavioral
finance challenges the assumption of perfect rationality in traditional finance,
acknowledging that human behavior can be irrational and influenced by emotions
and biases, which may not always align with traditional financial models.

4. Literature review
• Kahneman, (1979): Introduced prospects theory, challenging the traditional
economic rationality assumption by emphasizing how individuals make
decisions under uncertainty.
• Thaler (1980): Expanded on behavioral finance concepts, particularly
focusing on how cognitive biases affect economics decision and investor
behavior.
• Orum De Bondt and Thaler (1985) studied why investors sometimes behave
in certain ways and found that when stock prices revert to their average
values, it shows that investors tend to overreact. This means they put too
much importance on recent performance of companies when predicting
future performance.
• Gupta (1990) conducted a survey of households who invest money. The
goal was to gather information about what kinds of investments people
prefer, such as mutual funds (MFs) and other financial assets. The results of
 the survey were useful for policymakers and mutual funds because they
helped them create better financial products for the future.
• 1996, Madhusudhan V Jambodekar conducted a study to understand how
much people knew about mutual funds (MFs), what influenced their decision
to buy them, and why they chose one fund over another. The study found
that during that time, people preferred Income Schemes and Open-Ended
Schemes more than Growth Schemes and Close-Ended Schemes because of
the market conditions. Investors were most concerned about the safety of
their money, how easily they could access it (liquidity), and the potential for
their investment to grow. They mainly learned about mutual funds through
newspapers and magazines, and they also considered the quality of investor
services when choosing a mutual fund scheme.
• Odean (1999): Explored the “disposition effect,” showing how investors
tend to sell winning stocks too early and hold onto losing ones for too long,
thus deviating from rational decision-making
• Shleifer (2000): Examined the role of overconfidence, herd behavior, and
investor sentiment in market inefficiencies, highlighting behavioral aspects
impacting investment choices.
• Barbies (2003): Explored the implications of prospect theory in shaping
investor preferences and market anomalies, contributing significantly to the
understanding of behavioral finance.
• Kahneman (2006): Investigated the practical application of behavioral
finance in assets management, illustrating how biases affect investment
strategies and portfolio management.
• Genaille (2017): Explored how cultural and societal factors influence
financial decision-making, expanding the scope of behavioral finance
beyond individual biases to include broader environmental influences.
5. Behavioral Biases in Decision Making: Human psychology plays a significant
role in financial decision making, leading to various biases such as confirmation
bias, overconfidence, and loss aversion. These biases often cloud rational
judgment, affecting investment choices and risk assessment.
Emotional Influences on Investment Decisions: Emotions like fear, greed, and
sentiment significantly influence financial decisions. Fear can lead to selling assets
prematurely, while greed may drive individuals towards risky investments.
Understanding and managing these emotions are crucial for sound investment
strategies.
Herd Mentality and Market Trends: The tendency to follow the crowd or 'herd
mentality' impacts investment decisions, leading to market bubbles or crashes.
Analyzing the impact of social influence on investment behavior and its
consequences on market trends is imperative
Decision Making Under Uncertainty: Financial decision making is often carried
out amidst uncertainty. Behavioral economics delves into how individuals make
decisions under uncertain conditions and the subsequent effects on investment
choices and portfolio management.
Conclusion
Behavioral finance offers valuable insights into the psychological factors that
influence financial decision making. This field not only identifies the biases and
behavioral patterns that hinder optimal decision making but also provides avenues
for developing strategies to navigate these challenges. Understanding human
behavior in financial contexts is indispensable for enhancing investment outcomes
and promoting better financial stability and security for individuals and institutions
alike.
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