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Behaviour Finance (Week 1&2)

The document discusses Behavioral Finance, which examines how psychological factors influence financial decision-making and market behavior, contrasting it with Standard Finance that assumes rational investors. It highlights various market anomalies, such as the January Effect and the Disposition Effect, and introduces strategies like contrarian investing and behavioral portfolio theory. Additionally, it emphasizes the importance of psychological insights in understanding investor behavior, particularly in the context of the Pakistani market.

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arshadiqbal
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5 views

Behaviour Finance (Week 1&2)

The document discusses Behavioral Finance, which examines how psychological factors influence financial decision-making and market behavior, contrasting it with Standard Finance that assumes rational investors. It highlights various market anomalies, such as the January Effect and the Disposition Effect, and introduces strategies like contrarian investing and behavioral portfolio theory. Additionally, it emphasizes the importance of psychological insights in understanding investor behavior, particularly in the context of the Pakistani market.

Uploaded by

arshadiqbal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Behaviors Finance

By
Dr. ARSHAD IQBAL
ASSISTANT PROFESSOR
BUSINESS ADMINISTRATION & SOCIAL SCIENCES
Behaviors Finance

Week 1&2
Introduction to Behavioral Finance

• Concept: Behavioral finance studies how psychological factors affect financial


decision-making and market outcomes. It addresses the irrational behaviors
and cognitive biases that influence investors and market dynamics.
• Nature: Interdisciplinary, combining principles from psychology, economics,
and finance.
• Scope: Encompasses investor behavior, market anomalies, corporate financial
decisions, financial product design, and investment strategies.
• Objectives:
• Understand the impact of psychology on financial decisions.
• Explain and predict market anomalies.
• Improve financial models and strategies by incorporating behavioral insights.
• Develop financial education programs to mitigate irrational behaviors.
Difference between Standard Finance and Behavioral
Finance
• Standard Finance:
• Assumes rational investors.
• Efficient Market Hypothesis (EMH) holds that markets always reflect all available
information.
• Focuses on quantitative models and mathematical predictions.
• Behavioral Finance:
• Recognizes that investors are often irrational.
• Markets can be inefficient due to psychological biases.
• Uses both quantitative and qualitative methods to analyze market behavior.
• Traditional View of Financial Markets
• Efficient Market Hypothesis (EMH): Prices fully reflect all available information.
• Rational Investors: Investors act logically to maximize utility.
• No Arbitrage: Opportunities for risk-free profits are quickly eliminated by market
actions.
Anomalies of Financial Markets
• January Effect: Stocks often see higher returns in January, attributed to tax-
loss selling in December and new investments in January.
• Momentum Effect: Stocks that have performed well in the past tend to
continue performing well in the short-term.
• Disposition Effect: Investors are more likely to sell winning investments
and hold onto losing ones.
• Limitation of Efficient Market Hypothesis
• Behavioral Biases: EMH doesn't account for irrational behavior influenced
by cognitive biases.
• Market Anomalies: EMH fails to explain consistent patterns like the
January Effect or momentum.
• Psychological Influences: EMH overlooks how emotions like fear and greed
drive market movements.
Behavioral Financial Market Strategies
• Contrarian Investing: Investing against prevailing market trends, assuming
that market trends are driven by psychological biases.
• Behavioral Portfolio Theory: Building portfolios that consider investors'
psychological preferences and biases.
• Behavioral Indicators
• Sentiment Analysis: Analyzing news, social media, and other sources to
gauge investor sentiment.
• Market Breadth: Comparing the number of advancing stocks to declining
stocks to assess market sentiment.
• Put/Call Ratio: Measures market sentiment by comparing the volume of
put options to call options.
Psychology in Behavioral Finance
• Social Psychology: Impact of social factors and group behavior on financial decisions.
• Behavioral Psychology: Study of individual behaviors and mental processes affecting financial
decisions.
• Physiological Psychology: Examining how physiological responses, such as stress, influence
financial decision-making.
• Applied Psychology: Using psychological principles to design better financial products and
services.
• Educational Psychology: Understanding how financial education can improve investor behavior.
• Cognitive Psychology: Study of cognitive biases like anchoring, overconfidence, and availability
heuristic.
• Boom & Bust Cycles
• Boom: Periods of rapid market growth fueled by investor optimism and speculative bubbles. Bust:
Market crashes following a boom, often triggered by panic selling and loss aversion.
• Examples from the Pakistani Market:
• Boom: Rapid growth in the real estate sector from 2003-2007, driven by investor optimism and
speculative investments.
• Bust: The 2008 market crash caused by global financial turmoil and domestic economic issues.
Prospect Theory

• Developed by Daniel Kahneman and Amos Tversky: Describes how people make
decisions under risk.
• Value Function: Investors evaluate outcomes as gains or losses relative to a reference
point.
• Probability Weighting: People overestimate small probabilities and underestimate large
ones.
• Example: Investors in Pakistan may hold onto losing stocks longer than rational analysis
would suggest due to a higher sensitivity to losses compared to equivalent gains.
• Loss Aversion Theory
• Part of Prospect Theory: Investors are more averse to losses than they are attracted to
equivalent gains.
• Behavior: Leads to holding losing investments too long and selling winning investments
too soon.
• Example: Pakistani investors often avoid selling stocks at a loss, hoping for a rebound,
and might sell winning stocks prematurely to lock in gains.
Examples Relevant to the Pakistan Market

• Market Anomalies:
• Ramadan Effect: Research shows higher stock returns during Ramadan due to positive investor
sentiment and increased trading activity in sectors like consumer goods.
• Pre-Election Rally: The stock market often rallies before elections due to political optimism and
expectations of favorable economic policies.
• Behavioral Indicators:
• KSE-100 Index Sentiment: Sentiment analysis of the Karachi Stock Exchange can predict short-term
market movements based on investor mood and market news.
• Investor Overconfidence: Local investors might overestimate their knowledge and trade more
frequently, leading to increased market volatility.
• Boom & Bust Cycles:
• Boom: The real estate boom from 2003-2007 saw property prices soar as speculative investments
increased.
• Bust: The 2008 financial crisis led to a sharp decline in property and stock prices, exacerbated by
panic selling and economic uncertainty.
• Loss Aversion:
• Example: During market downturns, investors in the KSE-100 index often hold onto losing stocks,
waiting for a recovery rather than cutting losses, which can result in larger overall losses.

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