Behavioural Finance Notes
Subject Overview
The third Finance group elective, covering the theories of behavioural finance versus rational expectations, behavioural aspects of investing (heuristics, biases, overconfidence), investor behaviour types and market bubbles, and models of investor sentiment and behavioural corporate finance. A 4-credit elective theory paper.
Subject at a glance
4
Units
29
Topics
4
Credits
4
Infographics
Unit-wise Syllabus
4 units — open any unit for detailed topic-wise notes, diagrams and important exam questions
- Meaning
- features and scope of behavioural finance
- rational expectations paradigm and the behavioural challenge
- agency theory
- prospect theory
- reasoned emotions
- neo-classical finance and the Efficient Market Hypothesis
Investors are
Rational
Normal: subject to biases
Markets are
Efficient
Can misprice for long periods
Decisions use
Expected utility
Heuristics, emotions, framing
Key theory
EMH, CAPM
Prospect theory
Study guide
This unit covers the scope of behavioural finance, the rational expectations paradigm and its challenge, agency theory, prospect theory, reasoned emotions and the Efficient Market Hypothesis. Understand how prospect theory differs from expected utility.
- Heuristics and biases
- self-deception
- emotional and social forces
- firm-size effects
- momentum vs reversal
- noise trader risk
- mental accounting
- overconfidence
- excessive volatility
- loss aversion
- gambler's fallacy
Overconfidence
Too much trust in one's own judgement
Loss aversion
Losses hurt about twice as much as gains please
Mental accounting
Treating money differently by source
Anchoring
Fixing on a reference price
Herding
Following the crowd
Gambler's fallacy
Expecting a reversal after a streak
Study guide
You study heuristics, biases, self-deception, emotional and social forces, size effects, momentum and reversal, noise trader risk, mental accounting, overconfidence, volatility, loss aversion and the gambler's fallacy. Identify which bias appears in a recent market event.
- Types of investors by risk appetite
- conformity and contrarian investing
- group psychology on the board
- resistance to recognizing failure
- conflict of interest
- value vs growth investing
- stock market bubbles
Buys
Cheap stocks below intrinsic value
Fast-growing companies
Metrics
Low P/E, low P/B, high dividend
High earnings and sales growth
Mindset
Contrarian
Momentum
Study guide
You study investor types, conformity and contrarian investing, group psychology, resistance to admitting failure, conflicts of interest, value versus growth investing and bubbles. Study a historical bubble.
- Model of investor sentiment
- market efficiency and biases in brokerage recommendations
- evidence on cross-sectional stock return variation
- behavioural corporate finance
- 1Displacement
New technology or story
- 2Boom
Prices rise, attention grows
- 3Euphoria
Speculation, 'this time is different'
- 4Profit-taking
Smart money sells
- 5Panic
Prices crash
Study guide
You study investor sentiment models, biases in brokerage recommendations, cross-sectional return evidence and behavioural corporate finance. Consider how managers' biases affect corporate decisions.
Why Behavioural Finance Matters
Behavioural finance explains why markets and people do not always behave rationally, helping you avoid costly mistakes and advise clients better.
How to Prepare for Behavioural Finance
- Keep a journal of your own financial decisions and biases.
- Study bubbles and crashes as case studies.
- Learn the major biases with one example each.
Behavioural Finance: Frequently Asked Questions
What is loss aversion?
Loss aversion is the tendency to feel the pain of losses more strongly than the pleasure of equivalent gains.