Behavioral Finance

behavioral finance is a get word which involves the influence of psychology on the attitudes and behavior of clotheors and its subsequent effects on the markets. Behavioral Studies is liquid in its beginment stages, but it is instru psychic in determining/ explaining as to why or how markets might be inefficient. The difference between conventional finance and behavioural finance is that traditional finance is base on the following innovations Investors have rational behavior Capital Asset determine Model (CAPM) Markets argon efficientBehavioral finance on the other hand says that, the psychological forces interfere with these concepts. It says that there atomic number 18 both internal and external behavioral obstacles towards the value creation of any company. In practical terms it brings advancing the errors in judgments make by both individual investors and gillyflower managers and the different separatrixes to which we as humans are given up. Analyzing this wi ll place us in a position to make decisions which avoid errors/mistakes committed in the former(prenominal) . INVESTORS Individual investors An individual investor is a person who purchases little(a) amounts of securities for him/herself.He is not profession eachy involved in investment funds services and whatever purchases he/she makes are on an arms length basis. Individual investors are super regulated because they are thought of as amateurs with little or no association. An individual investor is alike known as retail investor or small investor . professional investor These investors are usually all those businesses which are involved in giving investment services either directly or indirectly for example, investment companies, mutual funds, investment banks, brokerage houses etc.Besides them professional investors could as well be individuals which are professionally involved in giving investment services. Professional investors are also known as institutional investors. These investors are pillow slip to fewer regulations likely because they are perceived as having superior knowledge to individual investors . Behavioral parti prises Individual and institutional investors are both pr one to almost similar biases, because institutional investors are although organizations in their own powerful but in actual are lead by a handful of managers.Proponents of this study argue that humans are disposed to bias in make their judgments no matter how qualified or go through they may be. They say that humans make frequent use of heuristic rules, mental shortcuts/rules of thumb to simplify decisions and tasks that are complex. Availability heuristic With availability heuristic it is believed that for humans the probability of an event occurring is dependent on how easily one can imagine that event happening. The more clear is the image the greater the probability.A related concept is Illusory correlation which describes we imagine and hence make up evid ence. Although this bias is express for retail investors since not only their investments are smaller but they also dont have various charts, patterns analyzing erstwhile(prenominal) twelvemonth data at their disposal, as for institutional investors this bias is at a much more magnified level because many fund managers use charts and technical analysis which according to them helps in identifying various patterns and value/stock moments . Representativeness heuristicThis concept says that humans are inclined making judgments that involve consideration of stereo-types instead of the underlying features. For example, while hiring the selection operate takes into consideration the qualifications, relevant experience, personality etc. however this in no way can predict the future job performance of the individual. This also incorporates a related concept called Illusion of validity which puts forward that the bureau in ones judgment is primarily based on the representation of th e situation instead of the characteristics.However, retail investors are more prone to this bias as compared to institutional investors because they have the entropy that is available to the widely distributed public for example, commentaries from financial journalists, analysts which believe that well known companies are heartfelt stock-market investment options, but in reality these two factors are by and large unrelated . Anchoring and adjustment This is another important heuristic according to which decisions make by humans are dependent on some secern value/number.There is no process or logic behind mark of this value/number it could be any random number. For example, budgeting which involves use of on-line(prenominal) figures to determine future estimates. Many fund managers use current year figures and current year industry averages to determine future estimates. This bias is a product of our inherent conservatism which leads to our under reaction to new information. In stitutional investors are more prone to this bias as compared to small investors. plausibly because the managers of investment companies actively use these techniques to draw conclusions.Small investors would hardly be certain so these techniques however those with an accounting background could be an exception . injury aversion It is also a key bias. It is based on the concept that humans find it very difficult to accept departure and the disk operating system of denial is such that we infact believe that holding onto it for longer periods of time would reversion things some way or the other. This bias has some major consequences in financial decision-making. For instance, over the years it has been seen that many companies have kept track loss-making units and destroying shareholder wealth to the level at which it was irreparable.The reasons behind the strength of this bias as scholars put it is the shame and regret and feeling the blame for the loss incurred. Individual in vestors are more prone to this professional investors, a study revealed that individual investors sell those stocks that start to perform well quite currently and hang on loss-making stocks for longer periods of time hoping that things might take a u-turn. This problem as professional traders put it is named get evenitis. Hindsight bias It is based on the concept that humans are prone to that feeling I knew it all the while or precisely hindsight bias.To correct this bias is also very difficult because its natural for us to make differing conclusions regarding what happened in the past even though those decisions would have been correct according to the data and circumstances at hand then. For example, these days since the global economy is in recession even a layman is heard that this was inevitable. Individual investors are prone to this bias out of human nature, as for institutional investors they are less prone to this because they would be having greater access to information all the time .Over-confidence bias Humans are naturally over-confident about their abilities normally. This bring forward leads to over optimism i. e. we normally feel that we can be successful in most of our endeavors or do the right thing in most of the situations. However in reality that is not possible. Moreover the more information or data one gathers regarding a task, the more that person feels in greater control this is called Illusion of knowledge. Practically the biggest setback that one has to visual modality with results unfolds is that they are quite different than what was expected.Individual investors are much less prone to this bias as compared to institutional investors which suffer a lot more, because the over-confidence of a team of managers would prove more lethal financially. For example, 3Com which acquired US Robotics in 2000 do an IPO of its division that made the famous Palm pilots. Although the share prices went as high as $165 making 3Com the fourth larg est technology faithful then but announcement of a forthcoming product without the stem yet in place saw its share prices dramatically regress to $1. 35 in 2001.This financial blunder was a result of a combined over-optimism of the then senior management. INVESTMENT BELIEFS Characteristics of the Individual investors investment beliefs would be focused on limited aspects probably because they have limited knowledge of the market and they invest smaller amounts as compared to institutional investors. They would probably invest in companies that have good market reputation and which cartel a good return within a short spoil of time. As for institutional investors their investment beliefs would be diverse since they are professionals.It would be important for them to take measures to avoid conflicts of interest. It would also be important for them to develop a clear view of capital markets in order to invest in companies that are expected to yield good returns . CONCLUSION Behavio ral finance has therefore highlighted that financial decision-making of both individual and institutional investors. The errors/mistakes made in yester-years both at the individual and organizational level if taken care of in future could result in making break long-term decisions. WORKS CITED Blanco. A.Behavioral finance Possibilities and Limitations of Different Approaches. Wiesbaden, 2003 Fortune. Why CEOs Fail. February 10th 2009 Retrieved from http//money. cnn. com/magazines/ hatful/, 1999. Goldberg. J. Behavioral pay. John Wiley, 2001. Montier. J. Behavioral Finance Insights into Irrational Minds and Markets. J. Wiley. 2002. Owen. A. S. Behavioral Finance and the Decision to Invest in High Tech Stocks. School of Finance and Economics, University of Technology, 2002 Pompian. M. M. Behavioral Finance and Wealth Management How to Build Optimal Portfolios That news report for Investor Biases.John Wiley and Sons, 2006. Redhead. K. Personal Finance and Investments A Behavioral Finance Perspective. Routledge, 2008 Shefrin. H. Behavioral Finance. Edward Elgar Pub, 2001. Shleifer . 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