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A Summary of Behavioral Finance


  • The central assumption of the traditional finance model is that people are rational. The behavioral finance model , however , argues that people suffer from cognitive and emotional biases and act in a seemingly irrational manner.
  • The important heuristic-driven biases and cognitive errors that impair judgment are : representativeness, overconfidence, anchoring, aversion to ambiguity, and innumeracy.
  • The form used to describe a problem has a bearing on decision making, Frame dependence stems from a mix of cognitive and emotional factors.
  • The prospects theory describes how people frame and value a decision involving uncertainty.
  • People feel more for a pain from a loss than the pleasure from an equal gain-about two and half times as strongly. This phenomenon is referred to as loss aversion.
  • People tend to  separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance to them.
    Image Courtesy Greekshares
  • Investors engage in narrow framing-they focus on changes in wealth that are narrowly defined, both in across-sectional as well as a temporal sense. Since people are loss averse, narrow framing leads to myopic risk aversion.
  • The psychological tendencies of investors prod them to build their portfolios as a pyramid of assets.
  • In general , people are willing to take more risk after earning gains and less risk after incurring losses.
  • Hope and fear have a bearing on how investors evaluate alternative. The relative importance of these conflicting emotions determines the tolerance of risk.
  • The heightened  sensitivity to what others are doing leads to the phenomenon called information cascade.
  • Behaviorist  believe that given the substantial presence of noise traders whose behavior is correlated and the limits to arbitrage operation by rational traders, investor sentiment plays an important role, In such a market, prices often vary more than what is warranted by fundamentals.
  • The strategies for overcoming psychological biases are: 
                 a)  Understand the biases
                 b)  Focus on the bigger picture
                 c)  Follow a set of quantitative investment criteria
                 d)  Diversify
                 e)  Control your investment environment
                 f)  Strive to earn market returns
                 g)  Review your biases periodically.  




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