Behavior

al
Finance :
NMBA
044
This document includes syllabus, tentative lecture plan and
tentative assignment plan which will be followed during even
semester 2015-16.

Prepared by:
Rachita
Manglik

NMBA 044: BEHAVIOURAL FINANCE

Max. Hours: 40

Course Objective
The purpose of this course is to introduce the student to the new field of behavioral finance. The theory is based
on the notion that investors behave in a rational, predictable and an unbiased manner. While behavioral finance
challenges this traditionally held notion. Reliant upon cognitive psychology decision theory, behavioral finance
is the study of how investors interpret and act on available, fallible information. This course will help the
students to identify persistent or systematic behavioral factors that influence investment behavior.
UNIT I (8 Sessions)
Behavioral Finance: Nature, Scope, Objectives and Significance & Application. History of Behavioural
Finance, Psychology: Concept, Nature, Importance, The psychology of financial markets, The psychology of
investor behavior, Behavioral Finance Market Strategies, Prospect Theory, Loss aversion theory under Prospect
Theory & mental accountinginvestors Disposition effect.
UNIT II (8 Sessions)
Building block of Behavioral Finance, Cognitive Psychology and limits to arbitrage. Demand by arbitrageurs:
Definition of arbitrageur; Long-short trades; Risk vs. Horizon; Transaction costs and short-selling costs;
Fundamental risk; Noise-trader risk; Professional arbitrage; Destabilizing informed trading (positive feedback,
predation) Expected utility as a basis for decision-making. The evolution of theories based on expected utility
concept.
UNIT III (08 Sessions)
Elsbergs paradoxes, Rationality from an economics and evolutionary prospective. Different ways to define
rationality: dependence on time horizon, individual or group rationality. Herbert Simon and bounded rationality.
Demand by average investors: Definition of average investor; Belief biases; Limited attention and
categorization; Non-traditional preferences prospect theory and loss aversion; Bubbles and systematic investor
sentiment.
UNIT IV (08 Sessions)
External factors and investor behaviour: Fear & Greed in Financial Market, emotions and financial markets:
geomagnetic storm, Statistical methodology for capturing the effects of external influence onto stock market
returns
UNIT V (08 Sessions)
Behavioral corporate finance: Empirical data on dividend presence or absence, ex-dividend day behavior.
Timing of good and bad corporate news announcement. Systematic approach of using behavioural factors in
corporate decision-making. Neurophysiology of risk-taking. Personality traits and risk attitudes in different
domains.
Suggested Readings:
1. Finding Financial Wisdom in Unconventional Places (Columbia Business School Publishing)
2. Bisen,pandey-Learning Behavioural Finance(Excel Books)
3. A History of Financial Speculation: Edward Chancellor
4. Forbes- Behavioural Finance (Wiley India)
5. The Little Book of Behavioral Investing (Montier)
6. The Psychology of Persuasion (Collins Business Essentials)
7. Sulphey- Behavioural Finance (PHI)
8. Sucheta Singh- Behavioural Finance (Vikas Publication)

Lecture Plan
Lec.
No.

Topic
Behavioral Finance: Nature, Scope,
Objectives.

Behavioral Finance: Significance &

Application.
History of Behavioral Finance
Psychology: Concept, Nature, Importance

UNIT 1

The psychology of financial markets

The psychology of investor behavior

Cov.

Book

.1

B:7, 4

.2

B:7, 4

.3

B:7, Ch: 3
B:8, Ch: 2

.6

B:4

.7

B:4

.8
.9

B:7, Ch: 5
B:7, Ch: 5

B:7, Ch: 5

Behavioral Finance Market Strategies

5
6
7
8
9
10

13
14

UNIT 2

11
12

15

17
18
19
20
21

UNIT 3

16

Prospect Theory
Loss aversion theory under Prospect Theory
Mental accountinginvestors Disposition
effect
Building block of Behavioral Finance,
Cognitive Psychology and limits to arbitrage.
Demand by arbitrageurs: Definition of
arbitrageur
Long-short trades; Risk vs. Horizon;
Transaction costs and short-selling costs;
Fundamental risk; Noise-trader risk;
Professional arbitrage;
Destabilizing informed trading (positive
feedback, predation)
Expected utility as a basis for decisionmaking.
The evolution of theories based on expected
utility concept.
Elsbergs paradoxes
Rationality from an economics and
evolutionary prospective.
Different ways to define rationality:
dependence on time horizon
individual or group rationality, Herbert
Simon and bounded rationality
Demand by average investors: Definition of

1.1

B:7, Ch:
2, 3

1.2

B:4

1.3
1.4

B:4
B:4

1.6

B:4, Ch:6

1.7

B:4

1.8

B:4, Ch: 2

B:4, Ch: 2

2.1

B:4, Ch: 2

2.2

B:4

2.4

B:4

2.5

B:7, Ch:2

2.6

B:4

Other Readings
http://www.investopedia.co
m/university/behavioral_fin
ance/

http://www.nios.ac.in/media
/documents/secpsycour/engl
ish/chapter-1.pdf
http://www.dailyfinance.co
m/2010/12/05/10-mistakesinvestors-make/
http://www.investopedia.co
m/articles/trading/06/behavi
oralfinance.asp
B: 4, Ch: 8

http://plato.stanford.edu/ent
ries/rationality-normativeutility/

average investor; Belief biases;

Limited attention and categorization
Non-traditional preferences prospect
theory and loss aversion;
Bubbles and systematic investor sentiment.
External factors and investor behaviour
Fear & Greed in Financial Market,

22
23
24
25
26

2.7

B:4

2.8

B:4

3
3.2

B:7, Ch: 6
B:4

3.3

B:4

3.4

B:4

3.6

B:4

3.7

B:4

3.8

B:4

B:4

emotions and financial markets: geomagnetic

storm

28

UNIT 4

27

30

31

32

33

35

36
37
38
39
40

UNIT 5

34

Statistical methodology for capturing the

effects of external influence onto stock
market returns
Statistical methodology for capturing the
effects of external influence onto stock
market returns
Statistical methodology for capturing the
effects of external influence onto stock
market returns
Statistical methodology for capturing the
effects of external influence onto stock
market returns
Behavioral corporate finance: Empirical data
on dividend presence or absence, exdividend day behavior.
Behavioral corporate finance: Empirical data
on dividend presence or absence, exdividend day behavior.
Timing of good and bad corporate news
announcement.
Systematic approach of using behavioural
factors in corporate decision-making.
Neurophysiology of risk-taking.
Personality traits and risk attitudes in
different domains.
Revision
Revision

4.2

B:4,
Ch:16

4.3

B:4,
Ch:16

4.4

B:7, Ch:9,
B:4, Ch:
15

4.6

B:7, Ch:9

4.8

B:7, Ch: 7

B:4, Ch: 5
http://www.investopedia.co
m/articles/01/030701.asp
B:4, Ch:6.3
http://optionalpha.com/the14-stages-of-investoremotions-and-tradingpsychology-10433.html

Assignment Plan
Sr. No.
1

2
3

Assignment
Prepare a Questionnaire and
conduct a survey to access
financial and investment
psychology of people.
Data compilation and
interpretation of the Survey
Write a Chapter Review of The
Little Book of Behavioural
Investing by James Montier
Track a financial/ Investment
news and develop an article
giving prediction about the
investor behavior along with the
occurring facts
Answer the questions

Objective

Evaluation Parameters
Questionnaire
To understand scope of Quality:15
behavioural finance
Survey Authenticity: 15
To understand scope of
behavioural finance
To get essence of
reputed writings of
experts

Structured data entry: 15

Tools and Analysis: 15
Content Coverage: 15
Writing Skills: 15

To develop market
intelligence and being
receptive to recent
changes

News follow up: 10

Article: 10
Factsheet: 10

Exam preparation and

revision

Max Marks: 30

Readings:
https://saylordotorg.github.io/text_personal-finance/s17-behavioral-finance-and-market-.html

Unit 1

Introduction:
Human beings sometimes make Errors in judgment. How these errors, and other aspects of human behavior,
affect Investors and asset prices falls under the general heading of behavioral finance.
Sooner or later, you are going to make an investment decision that winds up costing you a lot of money.
Sometimes you make sound decisions, but you just get unlucky when something happens that you could not
have reasonably anticipated. At other times (and painful to admit) you just make a bad decision, one that could
have (and should have) been avoided. The beginning of investment wisdom is to recognize the circumstances
that lead to poor decisions and thereby cut down on the damage done by investment blunders.
Behavioral finance is the area of finance dealing with the implications of investor reasoning errors on
investment decisions and market prices.
Behavioral finance, commonly defined as the application of psychology to finance
Sewell (2001) defined the behavioral finance as the study of the influence of psychology on the behaviour
of financial practitioners and the subsequent effect on markets. Behavioral finance is of interest because
it helps explain why and how markets might be inefficient.
Behavioral Finance closely combines individual behavior and market phenomena and uses the
knowledge taken from both the psychological field and financial theory . Behavioral finance attempts to
identify the behavioral biases commonly exhibited by investors and also provides strategies to overcome
them.
Behavioral finance is a new emerging science that studies the irrational behavior of the investors. It holds out
the prospect of a better understanding of financial market behavior and scope for investors to make better

investment decisions based on an understanding of the potential pitfalls. Advisers can learn to understand their
own biases and also act as a behavioral coach to clients in helping them deal with their own biases.

Nature;
Behavioral Finance is just not a part of finance. It is something which is much broader and
wider and includes the insights from behavioral economics, psychology and microeconomic
theory.
The main theme of the traditional finance is to avoid all the possible effects of individuals
personality and mindset.
Behavioral Finance as a Science
Behavioral Finance as an Art

Branches of Behavioural finance:

Behavioral finance models interpret phenomena ranging from individual investor conduct to market-level
outcomes. Therefore, practitioners and investors have identified two branches in behavioral finance
Behavioral Finance
1. Behavioral Finance Micro (BFMI) examines behaviors or biases of individual investors that distinguish
them from the rational actors envisioned in classical economic theory.
2. Behavioral Finance Macro (BFMA) detects and describe anomalies in the efficient market hypothesis that
behavioral models may explain.
BFMI:
It identifies relevant psychological biases in individual investment decision and investigate their influence
on asset allocation decisions so that we can manage the effects of those biases on the investment process.
With regard to BFMI, the debate asks: Are individual investors perfectly rational, or can cognitive and
emotional errors impact their financial decisions.
BFMA:

With regard to BFMA, the debate asks: Are markets efficient, or are they subject to behavioral effects?
These questions are examined.

Difference Between traditional and Modern Finance:

Traditional economic theory has always considered investors as fully rational decision-making entities. But over
the past few years, behavioral finance researchers have scientifically shown that investors do not always act
rationally or consider all of the available information in their decision-making process. They have behavioral
biases that lead to systematic errors in the way they process information for an investment decision. These
errors, because of their systematic character, are often predictable and avoidable. But they continue to occur
frequently and are made by both novice and professional investors alike.
traditional finance assumes that all investors are Rational Economic Men who a hold mean-variance optimal
portfolio that meets their return objective and tolerance for risk. The behavioral finance perspective is based on
observations that individuals do not actually behave as they are assumed to by traditional finance. Specifically,
individuals are susceptible to the types of behavioral biases which cause them to deviate from their mean
variance optimal asset allocation. Advisers need to recognize the behavioral biases that their clients exhibit and
may even need to modify portfolios in order to accommodate them.
There are Three economic conditions that lead to market efficiency: (1) investor
rationality, (2) independent deviations from rationality, and (3) arbitrage. For a market to
be inefficient, all three of these conditions must be absent. That is, it must be the case
that a substantial portion of investors make irrational investment decisions, and the
collective irrationality of these investors then must lead to an overly optimistic or
pessimistic market situation that cannot be corrected via arbitrage by rational, wellcapitalized investors.

Standard Finance

Behavioral Finance

Standard Finance believes in existence of

Rational Markets and Rational investors

Behavioral Finance believe in existence of

irrational markets and irrational Investors

Standard helps in building a rational

Behavioral finance helps in building an optimal

portfolio

portfolio

Standard Finance theories rest on the

assumptions that oversimplify the real
market conditions

Explanations of behavioral finance are in light

with the real problems associated with human
psychology

Standard Finance explains how investor

should behave

Behavioral Finance explains how does investor

behave

Standard Finance assumptions believe in

idealized financial behavior

Behavioral finance assumptions believe in

observed financial behavior

Scope:
1. To understand the Reasons of Market Anomalies:
2. To Identify Investors Personalities
3. Helps to identify the risks and their hedging strategies
4. Provides an explanation to various corporate activities
5. To enhance the skill set of investment advisors
Objective
1. To review the debatable issues in Standard Finance and the interest of stakeholders.
2. To examine the relationship between theories of Standard Finance and Behavioral
Finance.
3. To examine the various social responsibilities of the subject.
4. To discuss emerging issues in the financial world.
5. To discuss the development of new financial instruments
6. To get the feel of trend of changed events over years, across various economies.
7. To examine the contagion effect of various events.
8. An effort towards more elaborated identification of investors personalities.
9. More elaborated discussion on optimum Asset Allocation
Significance and Applications:
1. To develop better Advisory relationship

2. Formulating Financial Goals

Experienced financial advisors know that defining financial goals is critical to creating an investment program
appropriate for the client. To best define financial goals, it is helpful to understand the psychology and the
emotions underlying the decisions behind creating the goals. Advisors can use behavioral finance to discern
why investors are setting the goals that they are. Such insights equip the advisor in deepening the bond with the
client, producing a better investment outcome.
3. Maintaining a Consistent Approach
Most successful advisors exercise a consistent approach to delivering wealth management services.
Incorporating the benefits of behavioral finance can become a part of that discipline and would not mandate
large scale changes in the advisors methods.
4. Adds more Professionalism to Investment decision making
Behavioral finance can also add\ more professionalism and structure to the relationship because advisors can
use it in the process for getting to know the client, which precedes the delivery of any actual investment advice.
This step will be appreciated by clients, and it will make the relationship more successful.
5. Delivering What the Client Expects
Addressing client expectations is essential to a successful relationship; in many unfortunate instances, the
advisor doesnt deliver the clients expectations because the advisor doesnt understand the needs of the client.
Behavioral finance provides a context in which the advisor can take a step back and attempt to really understand
the motivations of the client. Having gotten to the root of the clients expectations, the advisor is then more
equipped to help realize them.
6. Ensuring Mutual Benefits
There is no question that measures taken that result in happier, more satisfied clients will also improve the
advisors practice and work life. Incorporating insights from behavioral finance into the advisory relationship
will enhance that relationship, and it will lead to more fruitful results.

It is well known by those in the individual investor advisory business that investment results are not the primary
reason that a client seeks a new advisor. The number-one reason that practitioners lose clients is that clients do
not feel as though their advisors understand, or attempt to understand, the clients financial objectives
resulting in poor relationships. The primary benefit that behavioral finance offers is the ability to develop
a strong bond between client and advisor. By getting inside the head of the client and developing a
comprehensive grasp of his or her motives and fears, the advisor can help the client to better understand why a
portfolio is designed the way it is and why it is the right portfolio for him or herregardless of what happens
from day to day in the markets.

History:
Sixteenths Century: Example of irrational investor behavior TULIP BULBS
A man named Conrad Guestner transported tulip bulbs from Constantinople, introducing them to Holland.
Beautiful and difficult to obtain, tulips were a consumer sensation and an instant status symbol for the Dutch
elite. Although most early buyers sought the flowers simply because they adored them, speculators soon joined
the fray to make a profit. Trading activity escalated, and eventually, tulip bulbs were placed onto the local
market exchanges. The obsession with owning tulips trickled down to the Dutch middle class. People were
selling everything they ownedincluding homes, livestock, and other essentialsso they could acquire tulips,
based on the expectation that the bulbs value would continue to grow. At the peak of the tulip frenzy, a single
bulb would have sold for about the equivalent of several tons of grain, a major item of furniture, a team of oxen,
or a breeding stock of pigs. Basically, consumers valued tulips about as highly as they valued pricey
indispensable, durable goods. By 1636, tulip bulbs had been established on the Amsterdam stock exchange, as
well as exchanges in Rotterdam, Harlem, and other locations in Europe. They became such a prominent
commodity that tulip notaries were hired to record transactions, and public laws and regulations developed to
oversee the tulip trade. Can you imagine? Later that year, however, the first speculators began to liquidate their
tulip holdings. Tulip prices weakened slowly at first and then plunged; within a month, the bulbs lost 90 percent
of their value. Many investors, forced to default on their tulip contracts, incurred huge losses.

Eighteen Century:
At this time, the concept of utility was introduced to measure the satisfaction associated with consuming a good
or a service. Scholars linked economic utility with human psychology and even morality, giving it a much
broader meaning than it would take on later, during neoclassicism, when it survived chiefly as a principle
underlying laws of supply and demand.

Year

Researcher

1759

Adam Smith

1776

Adam Smith

1870

1948

1996

1999

2001

Contributions
The Theory of Moral Sentiments described the mental and emotional
underpinnings of human interaction, including economic interaction
Wealth of Nations: focused on individual psychology than on production
of wealth in markets. The prospect of perfectly rational economic
decision making never entered into Smiths analysis.

Jeremy Bentham

psychological aspects of economic utility

William Stanley
Jevons
Carl Mengers
and
Leon Walrass

William Stanley Jevonss Theory of Political Economy (1871),

Carl Mengers Principles of Economics (1871), and
Leon Walrass Elements of Pure Economics (18741877)
Based on the assumption that individuals make perfectly rational economic
decisions, Homo economicus ignores important aspects of human
reasoning.
The assumption of being risk averse in standard finance is seriously
challenged by them.

Friedman and
Savage
Alan Greenspan
(The Federal
Reserve
Chairman)
Professor Richard
Thaler
(University of
Chicago)
Professor
Kahneman and
Amos Tversky

for raising concern for Irrational exuberance with respect to Japan

Studied investors behavior responsible for the creation of Tech Bubble.

Shefrin

They formulated the Prospect Theory. As a alternative to standard finance,

prospect theory described that the human judgements are influenced by
Heuristic and disagree with the basic principles of probability
Behavioral finance is defined as, A rapidly growing area that deals with
the influence of psychology on the behavior of financial practitioners.

Barber and
Odean

demographical features systematically influence individuals behavior and

their investment decision. Modern financial economics at times behave
with extreme rationality; but, markets dont.

Psychology
The word, psychology is derived from two Greek words, psyche and logos. Psyche means soul and
logos means science. Thus, psychology was first defined as the science of soul.
Psychology is concerned with all aspects of behavior and with the thoughts, feelings, and motivations
underlying that behavior. It keeps its importance both as an academic discipline and a vital professional
practice.
Psychology is an applied discipline to study mental functions and behavior of human beings. It systematically
explores human judgment and behavior in different situations
Traditional definition of psychology

Psychology as the science of mental processes by William James (1892).

Modern definition of psychology

Psychology as the science of the inner world by James Sully (1884).

Psychology as the science which studies the internal experiences by Wilhelm Wundt (1892).
Psychology as the science of behavior by William Mc Dugall (1905).
Science of behavior and experiences on human beings by B F Skinner.

Branches of Psychology:

Behavioral Psychology (Behaviorism)- believes in conditional learning of behavior

Social Psychology- studies behavior of society considering physiological and biological factors
Physiological Psychology- Studies interaction between behavior and body system, brain and hormones etc.
Applied Psychology- Practicing scientific knowledge of psychology to solve various problems.

Educational Psychology- It studies learning related psychic activities

Cognitive Psychology- Studying a metal process which derives a particular behavior. E.g. Perception

Nature Of Psychology:
1. Psychology as Science
There is consensus that the subject of psychology is a science as it is an objective study of the human brain. In
the process of attaining the objective, psychologists use experiments, observations, and various empirical
evidences. In science, the objective is pre-identified in a set of activities and so also in the field of psychology.
Hence, psychology is widely accepted as a science.
2. Psychology as Natural Science
Psychology is seen as a natural science because while dealing with human beings, the psychologist needs to
behave in his most natural manner. This behavior should be similar to the way a biologist deals with the subject.
3. Psychology as Social Science
as psychologists deal with the study of human behavior and society, psychology can justifiably be called a
social science.
4. Psychology as Positive Science
Normative science operates on logic or ought to be concept, whereas positive science deals with facts as
they are. Psychology, therefore, can also be called a positive science because it studies the behavior of
human beings.
5. Psychology as Applied Science
Psychology deals with the application of its principles in observing the behaviour of different individuals.
As each individual is unique, the application of basic thoughts will also be different in each case.

Importance of Psychology:
To explore the concepts of perception, cognition, attention, emotion, intelligence, personality, behaviour, and
interpersonal relationships of investors dealing in stock markets.
To explain how human beings differ from the way they are described by economists.
Identifying the behavioral biases that lead to market anomalies.
Understanding the psychology of investors will help their investment advisors
Study of psychology helps in maintaining and updating the investment portfolio
Helps in understanding the behaviour of markets, which actually show the combined effect of the investment
activities

Psychology of Economics:
To understand the influence of psychology on economic transactions, let us go back to the mid-eighteenth
century when classical economics began including the study of human behaviour for better understanding of
economic decisions.
In economics, it is assumed that the investor will take the most rational decision, which maximizes the Expected
Value of Utility Function U(x). Under psychological influences the expected utility becomes more realistic.
Jeremy Bentham, a famous thinker of his time, explained the principle of utility as approval or disapproval of
investors action according to the appearance of happiness to him. He further explained that every action
whatsoever seeks to maximize the utility. Later on Maximizing Utility concept was replaced with optimum
utility and concept of Bounded Rationality explained that Choices of investors are rational upto their
knowledge and cognitive capacity.
Psychology of Finance:

Market Psychology

Market psychology is defined as the overall sentiment of the market. Optimism, pessimism, fear, greed, and
various cycles of market are study areas of market psychology. Market psychology works on the concept of
behavioral analysis of financial markets, which was proposed by James Gregory Savoldi.

Boom And Bust Cycles

Boom and bust cycles are very prominent in financial markets. A very common example is of the Tech
Bubble. Usually bubbles are created because of an extended boom period which has to be followed by the bust
of the same.

Psychology of Investor:

Neurobiological Approach
Behavioral Approach
Cognitive Approach
Psychoanalytical Approach
Phenomenological/Humanistic Approach

Behavioral finance follows cognitive approach of psychology. Psychology also has the capacity to give
explanation to human errors committed towards maximizing utility.
Psychology of rational Investor: According to Neo-classical economics theory, the investor is Homo
economicus (rational). Homo economicus are those investors who show perfectly rational behavior and
take economic investment decisions based on perfect information. In light of various forms of Efficient
Market Hypothesis (EMH)
Criticism faced by Efficient Market Hypothesis (EMH)
Doubt Regarding Existence of Perfect Rationality
Doubt Regarding the Existence of Perfect Self-interest
Availability of Perfect Information
Psychology of Irrational Investor: Investors make their own beliefs after perceiving any information
received in their own different ways. They become overconfident about their actions and behave in an overoptimistic manner about the decisions taken.
All the above mentioned irrationalities make them trade too much and too often in stock markets, which
further leads to outcomes listed as follows:

Reduction in profits

Increased transaction costs

Undiversified risks

Wrong analysis of available information

Irrational pace of financial markets toward an information

Mainstream Finance Theories:

Standard finance is based on following four assumptions:
1.
2.
3.
4.
No.
1
2
3
4
5
6

Investors are rational

Markets are efficient
Investors should design their portfolio according to the rules of mean- variance portfolio theory
Expected returns are function of risk and risk alone.
Name
Harry Markowitz
Harry Markowitz
Merton Miller and Franco Modigliani
William Sharpe
Eugene Fama
S. A. Ross

Year
1952
1959
1961
1964
1965
1976

Contribution
Mean- Variance portfolio theory
Modern Portfolio theory
Investors are rational
Capital asset pricing theory
Efficient market hypothesis
Arbitrage pricing theory

Modern Portfolio Theory: By HARRY MARKOWITZ

This theory is based upon:

The expected return of a stock/ Portfolio

The standard deviation and its correlation with other stocks with in the portfolio.

It is possible to create an efficient portfolio for any group of stocks. Given the amount of risk assumed, the
efficient portfolio would have the highest expected return on investment, as well as the lowest possible risk.
It is possible to create any number of portfolios with a given set of securities. This can be done by altering the
proportion of funds invested in each security. Due to diversification, some portfolios may be efficient than
others, offering lower risk or higher returns. Market risk/ systematic risk is non-diversifiable.
Miller and Modigliani Theory:
According to this theory, the capital market is assumed to be perfect, and both insiders and outsiders have
symmetric information and value of a firm is unaffected by its capital structure. It assumed that there exists no
transaction cost, bankruptcy cost or distortionary taxation; choice between equity and debt becomes irrelevant.
Capital asset pricing model:

CAPM provides a framework to assess whether the security is underpriced/ Overpriced/ correctly priced.
Assumptions of this theory are:

All investors aim to maximize economic utility

They cannot influence prices
They trade without transaction or taxation costs
The investors are simultaneously in possession of all information

Arbitrage pricing theory:

Arbitrage assumes that when investors seek to exploit excess profit opportunities that may arise as a result of
drifts away from the fundamental value, the activity of certain speculators will increase the demand for it.
Higher demand will drive up the prices, thereby leading to adjustment in prices, thus eliminating the
opportunity for excess profits.
Efficient market Hypothesis:
EMH considers efficiency in three different forms based on the type of information.
No.
1
2
3

Form
Weak
Semi strong
Strong

Description
Information regarding the past sequence of security movement is dealt with
Information that is publicly available
All forms of information- public, private and inside

Other theories are Random walk hypothesis, Expected utility theory etc.

Behavioral Finance Market Strategies:

Howard Raiffa provided an approach to strategize against market uncertainty while decision-making in 1968.
The strategy proposed by him can be divided into three approaches as follows:

Normative analysis: What should be ideal outcome of a decision that has been made?

Descriptive analysis: Which factors should be considered?

Prescriptive analysis: Application of practical tools to minimize the gap between expected and actual
outcome

Market timing:
The most difficult thing in stock market is Timing the Market. Most bubble creations are largely a matter of
timing. If an investor gathers the information about the fundamental parameters and the market response
towards an industry, the investor can create a bubble and invest just before it begins and divest just before it
bursts. This exercise will fetch the investor maximum returns.
Buy and hold strategy:
Investors create a diversified portfolio, hold and monitor it. But this strategy is affected by behavioral patterns.
This strategy is further subdivided into:

Passive Investment Strategy

Active Investment strategy

Technical analysis as a tool

Technical Analysis is a helpful tool in analyzing the past trends and estimation of future events of a stock or the
market. Technical analysis provides various theories (for example, Dow Jones Theory, Elliot Wave Theory) that
explain that the market moves in trends and hence, the previous trends can provide estimation about the
upcoming trend.

Behavioral indicators:
Behavioral indicators are used to explain the reasons to why most of the investors, who are termed as crowd
underperform, even if they copy the strategies of investment advisors. Two leading indicators of investor
behavior are listed as follows:
Put-call ratio:
In the option markets, the Put position is held by investors who are bearish about the market, whereas the
Call buyers are believers in an upcoming bullish trend. Thus, a high Put-Call ratio indicates pessimism in the
market, whereas a low Put-Call ratio on the other hand, implies a lot of optimism.
Moving average etc.