Professional Documents
Culture Documents
Khushboo Tibrewal
Khushboo Tibrewal
“Behavioural Finance”
Khushboo Tibrewal,
Indian Law Society’s Law College,
Pune
ABSTRACT
Behavioral finance involves the practice of observing and studying the behavior of an
investor or a group of investors while making economic decisions. It helps in making
understand the rationale behind economic decisions of investors and is a nexus between the
psychological theories and the conventional theory on economics and finance. Understanding
behavioral finance through adaptation of different models and theories will help in modifying
the behavior of investors and enable them to achieve improved economic decisions.
The Research paper is done with the aim of making understand the concept of behavioral
finance and its importance by comparing it with traditional finance. The objective is also to
highlight the pillars and theories of behavioral finance along with the behavioral biases and to
substantiate the theories, appropriate research and analysis is also carried out in this regard to
observe how the behavior and emotions of investors drive their economic decisions.
RESEARCH METHODOLOGY
2. Limitations
The topic is about understanding human behavior, attributes and their reaction towards
economic decisions. Because of the subjective nature of humans, the prediction and analysis
on their behavior can never be accurate. The theories, research and analysis made in the paper
tries to achieve maximum accuracy, however due to no certain laws on human behavior
which can accurately interpret human ways and conduct, the research paper is done with
much caution and skepticism.
3. Research Questions
www.penacclaims.com Page 1
Volume 10, May 2020 ISSN 2581-5504
c. What are the circumstances under which the theories under efficient market hypothesis
does not hold good and contradicts the concept of behavioral finance?
INTRODUCTION
One of the notional concepts under economics and finance is that people behave rationally to
achieve their objective of wealth maximization, giving no place to softer aspects of human
nature such as emotions, habits and behavior while making finance decisions. This concept
however was analyzed and tested with times to know that the assumption did not hold good
in its entirety when applied in the real world. For instance, we take the example of betting,
gambling, lotteries, where the winning probability is negligible (approx. 1 in 146 million),
still people tend to try their fate on such activities.
The presence of such instances, led the researchers to delve into the area of understanding the
irrational behavior of individuals which modern finance has overlooked. Behavioral finance
thus has become a new area of study and development to find out the underlying forces for an
investor while making investment concerning their cognitive ability and behavior1.
There are evidences back from the past where academicians, scholars have coined the term
behavioral finance and germinated its recognition in the field of economics and finance. John
Keynes, in his book in the year 19632 stated that, “many of our long-term investments reflect
“animal spirits”—intuitions and emotions—not cool-headed calculation”. Herbet Simon and
Hayek, in 19693 mentioned in their book that, “human beings can process only so much
information at once and are not capable of carefully weighing the costs and benefits of every
possible outcome of their decisions”. Contemporarily, The World Development Report4, in
2015 described the concept as, “Even apart from the instability due to speculation, there is the
instability due to the characteristic of human nature that a large proportion of our positive
activities depend on spontaneous optimism rather than mathematical expectations, whether
moral or hedonistic or economic. Most, probably, of our decisions to do something positive,
the full consequences of which will be drawn out over many days to come, can only be taken
as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as
the outcome of a weighted average of quantitative benefits multiplied by quantitative
probabilities.”
1
Martin Sewell, Behavioral Finance, University of Cambridge (First Published in February 2007, Revised in
April 2010), available at <http://www.behaviouralfinance.net/behavioural-finance.pdf> (last visited on 30-05-
2020)
2
John Maynard Keynes, The General Theory of Employment, Interest and Money (First Published in 1936),
available at < http://www.hetwebsite.net/het/texts/keynes/gt/gtcont.htm> (last visited on 31-05-2020)
3
Herbert Simon and F.A. Hayek, The Sciences of the Artificial ( First Published in 1969), available at
<https://monoskop.org/images/9/9c/Simon_Herbert_A_The_Sciences_of_the_Artificial_3rd_ed.pdf> (last
visited on 30-05-2020)
4
World Development Report,2015:Mind, Society, and Behavior, available at
<https://www.worldbank.org/en/publication/wdr2015> (last visited on 31-05-2020)
www.penacclaims.com Page 2
Volume 10, May 2020 ISSN 2581-5504
Few notable research works in the field of Management of Working Capital are of “Daniel
Kanheman” and “Annes Tversky”, who are considered as the “Fathers of Behavioral
Finance”. They have contributed in the field by their publication, counting to approximately
200 on various theories, models on behavioral finance, cognitive and emotional biases that
result in unanticipated behavior of individuals. Kanheman, in the year 2012 was also the
recipient of Nobel Prize for his work in the area of ‘rationality’ in economics. Their theories
were further developed and evolved by Richard Thaler, who worked on the shortcomings and
gaps left by the former researchers. He gave a new dimension to the research by elaborating
on concepts like prospect theory, endowment theory and other biases.
Understanding behavioral finance will help the Companies to create a management plan to
deal with the bad assumptions of investors and will also help them to provide for ways to
tackle foolishness and irrationality of humans.
a.) Traditional finance can be grouped under normative analysis which is concerned with
deriving rational solutions to problems in hand. Behavioral finance is grouped under
descriptive analysis that concerns the manner in which people actually behave while making
decisions.
b.) The basis of traditional finance is from neo-classical economics which holds on to the
concepts of rational investors who are risk averse and efficient market, where the price
reflects all available information and to that effect, market behaves accordingly6. Behavioral
finance finds its place from psychology i.e. applying the theories of psychology in finance. It
deals with the myriad investor behavior patterns and approaches towards a situation and
examining it.
c.) The concept on which the traditional finance works is “Perfect Rationality” which states
that a “Rational Economic Man” has the ability to work optimally towards the solution for
any complexity and to choose the best alternative for best outcome. However, such a perfect
combination is hard to exist and hence comes the concept of behavioral finance which adopts
5
Ms. Kavita Shah, Study of Behavioral Finance With Reference to Investor Behavior, available at
<https://www.ijaiem.org/Volume3Issue9/IJAIEM-2014-09-28-67.pdf> (last visited on 31-05-2020)
6
Nicholas Barberis and Richard Thaler, A Study of Behavioral Finance (First Published in September 2002)
available at < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=332266> (last visited on 31-05-2020)
www.penacclaims.com Page 3
Volume 10, May 2020 ISSN 2581-5504
the “bounded rationality” theory that throws light upon human emotions than human intellect
and explains how a person’s anger, fear, hatred, love and pleasure can affect its decisions.
7
Victor Ricciardi, The Psychology of Risk: The Behavioral Finance Perspective (First Published in July 2008),
available at < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1155822> (last visited on 31-05-2020)
8
Kahneman and Tversky, Prospect Theory: An analysis of decision under risk (Econometrica, First Published in
1979, Vol.47. No. 2) pp. 263-292
www.penacclaims.com Page 4
Volume 10, May 2020 ISSN 2581-5504
1. Mental accounting: According to this concept, people have an inclination for assigning
special functions to each asset group, while ignoring the debt payment obligations it has in
the present9. The theory can be better explained with an example. An individual creating a
specific head and assigning funds for a family vacation, while it has credit card debt for
payment becomes illogical as the person is saving funds bearing little or no interest value
while upholding a 25% interest on a credit card debt payment.
In matters of investment, this theory comes in place where investors diversify their portfolio
between safe and speculative portfolios to counter the negative returns ignoring the fact that
the net wealth will remain unaffected than in the case if he had held larger portfolio.
Although such behavior seems illogical, people tend to do it as they have certain value
attached to assets which they feel “too important” to relinquish.
To mitigate the mental accounting bias, it is to be understood that the money is the same
which is saved for a purpose bearing negligible interest and can be used to save high interest
payments. The fungible nature of money, if recognized can help avoid the irrational behavior
of individuals.
2. Gambler’s fallacy: The theory is based on determining the probability of event or series
of events. A lack of understanding can result in wrongful assumptions about a particular
event. In gambler’s fallacy, an individual bases the probability of the happening or non-
happening of event on the criteria of the result of past series of events ignoring the fact that
the probability of each event is independent of its occurrence in the past10. For instance,
where a series of 10 coin flips shows “tails” side up each time, an individual may predict that
the next flip will most likely have “heads” although each coin flip is independent and no past
flips have any bearing on future flips.
In investments people fall prey to this bias. For example, investors decide to liquidate a stock
where it has witnessed growth for a considerable period assuming that it is unlikely for the
stock to continue growing. Similarly, investors might hold up to a stock even after its
continuous downfall assuming that further downfall is improbable and the situation will
change.
The gambler’s fallacy can lead to wrong assumptions and predictions. Investors should hence
decide on the basis of fundamentals and technical analysis and must educate themselves
before investing.
9
Richard Thaler, Mental Accounting Matters (First Published in July 1999) available at
< https://doi.org/10.1002/(SICI)1099-0771(199909)12:3%3C183::AID-BDM318%3E3.0.CO;2-F> ( last visited
on 31-05-2020)
10
Dek Terrell, A test of the Gambler’s Fallacy: Evidence from pari-mutuel games ( First Published in May
1994) available at < https://doi.org/10.1007/BF01064047> (last visited on 31-05-2020)
www.penacclaims.com Page 5
Volume 10, May 2020 ISSN 2581-5504
3. Overreaction bias: The changes in the stock market due to the new information provided
in the market often leads to overreaction by the investors11. For instance, when there is some
good news, it is assumed that the news should raise the price of the stock and shall remain
rising until any further information is provided.
Overreacting over such actions in the market, investors tend to create larger than appropriate
effect in the market often overlooking that the price change is sudden and temporary. Basing
their investment decisions on such temporary factors can lead to irrationality in their behavior
and therefore instead of a hasty decision, investors should spend time on watching the market
and the stock movements and then arrive at a decision.
4. Availability bias: According to this theory, investors act on the basis of recent trend and
newer information in their decision making than considering old information and data for
investments. For instance, if one sees a car accident on the road which the person takes
regularly to drive to office, the person will become extra cautious for a week or so while
driving along he same road although the road has not become more dangerous than it has ever
been, but the accident made the person skeptical, but the person will adopt his old driving
habit by the following week.
On avoiding overconfidence bias, it needs to be understood that the volatility of the stock
market and the new set of challenges associated with it needs proper study and research.
Refining the investment techniques can also be adopted as one of the ways to avoid
overconfidence.
11
Srinivasan Rangarajan, Behavioral Finance: Overreaction and Availability Bias (Published in May,2014),
available at < https://getricher.in/2014/behavioural-finance-overreaction-and-availability-bias/> (last visited on
31-05-2020)
12
John Doukas and Dimitris Petmezas, Acquisitions, Overconfident Managers and Self-attribution Bias (First
Published in May 2007) available at <https://doi.org/10.1111/j.1468-036X.2007.00371.x> (last visited on 31-
05-2020)
www.penacclaims.com Page 6
Volume 10, May 2020 ISSN 2581-5504
Average Average
Current Average
Name of Interest Profit Sales Growth
Market P/E D/E ROE
company Coverage Growth Growth Rate
Price (5yrs)
(5yrs) (5yrs)
Tata Global 260.60 42.24 0.12 8.17 1.43 0.29 6.52 3.56%
Bombay
1187.60 19.15 0.42 30.52 21.10 9.64 17.89 12.09%
Burmah
Tata Coffee 118.65 14.67 0.72 9.66 20.19 0.03 14.62 11.53%
Observations13
1. On the basis of Debt/Equity Ratio (D/E ratio), Dhunseri Tea is the riskiest company
out of the 4 companies.
13
The observations are solely on the basis of the information extracted from the box above and no additional
inputs have been referred.
www.penacclaims.com Page 7
Volume 10, May 2020 ISSN 2581-5504
2. On the basis of Interest Coverage Ratio, Dhunseri Tea is the riskiest company out of
the five companies.
3. The average sales growth of Dhunseri Tea for last five years has been 4.13%. During
the same time, the profit has decreased by 1.30%. This shows that the cost per unit of
production has increased during the period.
4. The Growth rates for the Companies were also calculated to evaluate the future
prospects of the Companies. The growth rate has been calculated using the formula (
Retention Ratio * Return On Equity )
5. Due to 100% Dividend Payout and no Retention in the last year, there is no growth
rate for Dhunseri Tea.
Following the observations, it can be said that if the EMH assumptions are implemented then
Dhunseri Tea should have traded at a lower P/E Ratio as compared to the peers however, the
investors are willing to pay 5-6 times more than what they are willing to pay to its peers
despite the weak fundamentals of Dhunseri Tea. It therefore shows how the decisions of
investors are not always rational and that the price doesn’t reflect all available information.
Source: Valueresearchonline.com
Observations: ICICI Prudential Value Discovery Fund has been regularly out-performing
the corresponding Index from 2009 onwards.
14
Michael Jensen, The Performance of Mutual Funds in the period 1945-1964 (First Published in May 1968),
available at < https://doi.org/10.1111/j.1540-6261.1968.tb00815.x> (last visited on 31-05-2020)
www.penacclaims.com Page 8
Volume 10, May 2020 ISSN 2581-5504
Source: Valueresearchonline.com
Observations: UTI Equity Fund has been regularly out-performing the corresponding Index
from 2009 onwards.
Source: Valueresearchonline.com
Observations: Sundaram S.M.I.L.E. Fund - Regular Plan has been regularly out-performing
the corresponding Index.
3. Cases where individual stock has outperformed the mutual funds in the market
In contrary to above observations, there are cases where the individual stocks of the entity has
performed better and the investor has gained higher return after investing in the individual
stocks through thorough study and analysis of fundamentals as compared to return from
Mutual Funds.
For analyzing the same, the top 3 companies in UTI Equity Fund portfolio were taken on the
basis of percentage holding of assets and the return from Mutual Funds were compared with
the return from individual stocks and the results were as follows –
www.penacclaims.com Page 9
Volume 10, May 2020 ISSN 2581-5504
Source: Valueresearchonline.com
Source: Valueresearchonline.com
www.penacclaims.com Page 10
Volume 10, May 2020 ISSN 2581-5504
Source: Valueresearchonline.com
Observations: Thus it is evident that although Investment Managers tend to outperform the
market by taking benefit of the opportunities and having strong fundamentals, it may so
happen that individual investors through their research on market behavior as well as their
findings may earn higher return on individual stocks than what they could have earned
through investing in Mutual Funds.
News No. 1: Lupin hits over one-year low on speculation of Rakesh Jhunjhunwala
selling some of his stake. (Business Line, 18th March, 2016)
The Business Line reported on March 18, 2016 that the ace investor Rakesh Jhunjhunwala
is expected to sell some of his stake soon15. In no time, after the news was broadcasted, Lupin
Limited fell as much as 8.32% to its lowest since February 3, 2015 in intra-day trade. The
stock continued to fall post March 18, 2016 which evidently displays the herd behavior.
15
The Hindu Business Line, Lupin shares partly recover after hitting 52 - week low, available at
<https://www.thehindubusinessline.com/markets/stock-markets/lupin-shares-partly-recover-after-hitting-
52week-low/article8409172.ece> (last visited on 31-05-2020)
www.penacclaims.com Page 11
Volume 10, May 2020 ISSN 2581-5504
1,700
1,600
1,500
1,400
17th 18th 21st 22nd 23rd
March, March, March, March, March,
2016 2016 2016 2016 2016
News No. 2: Rakesh Jhunjhunwala buys 3 million shares of Man Infra (Live Mint, 29th
Jan, 2015)
The Live Mint reported on January 29, 2015 that Mr. Jhunjhunwala buys 1.21% stake i.e. 3
million shares in Man Infra Constructions Limited at Rs. 36 per share16. Soon after the report,
the stock price witnessed a hike with closing at 20% higher i.e. Rs. 43.2 per share on Bombay
Stock Exchange.
16
The Live Mint, Rakesh Jhunjhunwala buys 3 million shares of Man Infra, available at
<https://www.livemint.com/Money/ZzKJAghlfSnozlJrOxK5BP/Rakesh-Jhunjhunwala-buys-3-million-shares-
of-Man-Infra.html> (last visited on 31-05-2020)
www.penacclaims.com Page 12
Volume 10, May 2020 ISSN 2581-5504
50
40
30
20
10
0
23rd Jan, 27th Jan 28th Jan, 29th Jan, 30th Jan, 2nd Feb,
2015 , 2015 2015 2015 2015 2015
As clearly understood from the graph, the stock was on a deteriorating trend until the news of
Mr. Jhunjhunwala buying the shares resulted in an upward movement in the price of stock up
to Rs. 43.2 from Rs. 36 in a single day and kept on increasing for the next 2-3 days.
Thus, it can be wrong to say that investors are always rational in their approach and instances
such as the herd behavior where the investors follow the renowned investors show that they
are normal rather than rational.
ANALYSIS
Behavioral finance involves the study of rationale behind investors’ decisions. The gaps in
the theories of conventional finance which explains investors as rational and market as
efficient are filled by behavioral finance. The pillars of behavioral finance, namely, risk
aversion, neuro-economics, prospect theory and bounded rationality are the foundations of
behavioral finance that has evolved over a period of time. Also, the behavioral biases
mentioned in the research paper are the prejudices which lead to the irrationality of investors
while making investment as it ignores the market behavior and future prospects and putting
focus only on investors’ emotions, intuitions which are not backed by any fundamentals or
research. The famous prospect theory propounded by Kahneman and Tversky determines that
people tend to be more loss sensitive i.e. they feel more pain in receiving a loss as compared
to the joy which the person receives from an equal amount of gain.
The research section of the research paper hits the underlying assumptions in efficient market
hypothesis. The data analysis on “Valuation not justified by fundamentals” contradicts the
assumption that market participants are rational beings, making optimal decisions by trading
off costs and weighing the benefits statistically. There are number of examples of companies
where the valuation is not justified by fundamentals and is not just limited to one or two
industries, rather they are pervasive.
The research catering to the mutual funds outperforming the market brings down another
assumption of market efficiency that relevant information is freely available to all the
investors and the competition among the market participants result in a market where prices
of individual investor always reflect the total effect of all information which includes
www.penacclaims.com Page 13
Volume 10, May 2020 ISSN 2581-5504
information about events that have already happened and that are expected to happen in
future.
The herd behavior of investors shown in the research portion of the paper puts down the
efficient market assumption that investors study the market and theories on investment before
investing. It shows that they just follow the movement of ace investors in the market without
putting heed on the stock performance, its fundamentals and future prospects. Thus, the fact
that investors do not take rational decisions provides opportunities to the investment
managers to outperform the market.
Greed and fear have always been a dominating trait in investment decisions. The
unprecedented situation caused due to the Corona Virus has made people to more likely take
wrong decisions and the uncertainty has made it difficult to respond to the market with
accuracy. In this regard, it is important to mention the role of narratives. Narratives or public
sentiment is an essential factor in making decisions even in this pandemic with respect to the
savings and investment plans. The investors’ behavior are although changing as they are
willing to ride out the storm and even add more money during the bad phase of the market,
however it is important for them to not panic or overreact. The investors should hold back to
their stocks and act at the appropriate time rather than taking decisions in a haste and getting
followed by the behavioral biases ending up in irrational decision making. Thus, it is better to
be calm before taking big and long term investment decisions looking at the prevailing
situation.
Certain contemporary events such as the outbreak of Corona Virus, hike in the crude oil
prices and the YES Bank case where it was put under moratorium have impacted the market
and caused deterioration in the stock performances, however it can also be seen as an
opportunity in disguise as the Government and the RBI have been constantly handling the
situation to prevent negative fallout of the situation.
Thus, it needs to be understood that what is being experienced now is volatility and not
absolute loss. The markets have always revived through the doom and gloom as evident from
the past where in 2008, Nifty collapsed to a low of 2,600 level from highs of 6,200 level in
January 2008. At that time it was predicted that the market might take a decade to recover,
however, the market was back to 6,100 level by October 2010 i.e. in just eighteen months.
History has shown with time the continued progress of mankind and has assessed that there is
no reason that the trend will not reverse this time. Staying on course is what is expected from
the investor.
CONCLUSION
Behavioral finance strikes a balance between traditional finance and modern finance as
traditional finance safely does away with considering psychological factors of investors in
making decisions which ultimately changes the market prediction and outcomes. Modern
www.penacclaims.com Page 14
Volume 10, May 2020 ISSN 2581-5504
finance, on the other hand, recognizes an investor’s emotions, intuitions and thought process
behind any investment decision. Understanding behavior is as difficult as predicting weather
and in fact more difficult as the economy, unlike weather is not made up of molecules for
which the law of physics can provide any conclusion. There are no concrete laws on human
behavior and conduct unlike the law of physics. However, this limitation cannot become the
reason to overlook behavioral finance, but the approach should be to study and understand it
in a broader sense so that it can be complimented along with the traditional finance so as to
improve the economic decision of investors.
Thus, in the volatile market situations, it is important to keep in mind both the fundamentals
of the stock and the market as well as the behavior, attitude of investors and their investment
patterns so as to achieve improved economic decisions by the investors which will provide an
efficient market system and increase in investment base resulting in an upliftment of the
economy.
REFERENCES
www.penacclaims.com Page 15
Volume 10, May 2020 ISSN 2581-5504
10. Dek Terrell, A test of the Gambler’s Fallacy: Evidence from pari-mutuel games ( First
Published in May 1994) available at < https://doi.org/10.1007/BF01064047> (last visited on
31-05-2020)
11.Srinivasan Rangarajan, Behavioral Finance: Overreaction and Availability Bias (Published
in May,2014), available at < https://getricher.in/2014/behavioural-finance-overreaction-and-
availability-bias/> (last visited on 31-05-2020)
12. John Doukas and Dimitris Petmezas, Acquisitions, Overconfident Managers and Self-
attribution Bias (First Published in May 2007) available at <https://doi.org/10.1111/j.1468-
036X.2007.00371.x> (last visited on 31-05-2020)
13. The observations are solely on the basis of the information extracted from the box above
and no additional inputs have been referred.
14. Michael Jensen, The Performance of Mutual Funds in the period 1945-1964 (First
Published in May 1968), available at < https://doi.org/10.1111/j.1540-6261.1968.tb00815.x>
(last visited on 31-05-2020)
15. The Hindu Business Line, Lupin shares partly recover after hitting 52 - week low,
available at <https://www.thehindubusinessline.com/markets/stock-markets/lupin-shares-
partly-recover-after-hitting-52week-low/article8409172.ece> (last visited on 31-05-2020)
16. The Live Mint, Rakesh Jhunjhunwala buys 3 million shares of Man Infra, available at
<https://www.livemint.com/Money/ZzKJAghlfSnozlJrOxK5BP/Rakesh-Jhunjhunwala-buys-
3-million-shares-of-Man-Infra.html> (last visited on 31-05-2020)
www.penacclaims.com Page 16