Unit 1: Introduction to behavioural finance

Behavioural finance studies how psychological, emotional, cognitive and social factors influence the financial decisions of individuals and institutions and, through them, market prices.

• Features: draws on psychology, sociology and economics; recognises bounded rationality; explains anomalies that standard models cannot; descriptive (how people decide) rather than only normative (how they should decide).
• Scope: individual investor behaviour (micro behavioural finance), market-level anomalies and bubbles (macro behavioural finance), corporate financial decisions, financial advice and product design, regulation and investor protection.
• Pioneers: Daniel Kahneman and Amos Tversky (prospect theory), Richard Thaler (mental accounting, nudges), Robert Shiller (excess volatility, bubbles), Hersh Shefrin and Meir Statman.

• Neo-classical (standard) finance assumes investors are rational, risk-averse utility maximisers; markets are efficient; portfolios are built on mean–variance (Markowitz); assets are priced by CAPM; arbitrage removes mispricing (Modigliani–Miller).

Efficient Market Hypothesis (Eugene Fama, 1970): security prices fully reflect all available information; hence consistently earning above-normal returns is not possible.

• Tests: weak form — serial correlation, runs tests, filter rules; semi-strong — event studies (earnings, splits, bonus); strong form — performance of insiders and fund managers.
• Random Walk Theory (Malkiel): successive price changes are independent and random, so past prices cannot predict future prices — consistent with weak-form efficiency.
• Evidence and anomalies: January effect, small-firm effect, momentum, value premium, bubbles — and behavioural finance explanations (overconfidence, herding).
• Implications: passive investing (index funds), diversification, low-cost strategies.

• Rational expectations (Muth, Lucas): agents' forecasts are, on average, correct and use all available information.
• Behavioural challenge: evidence of anomalies (momentum, excess volatility, bubbles, the equity premium puzzle), experimental evidence of systematic errors, and limits to arbitrage (fundamental risk, noise-trader risk, implementation costs) mean mispricing can persist.

• Agency relationship: principals (shareholders, investors) delegate decisions to agents (managers, fund managers, brokers), whose interests may differ.
• Agency problems: managers' empire-building and perquisites, short-termism, excessive risk-taking or excessive caution; fund managers herding to protect careers; brokers churning accounts.
• Behavioural angle: managers' overconfidence and optimism add to agency costs; incentives can be distorted by framing and reference points.
• Mitigation: performance-linked pay, independent boards, disclosure, fiduciary duties, regulation.

Kahneman and Tversky (1979) describe how people actually choose under risk.

• Value function: S-shaped — risk-averse for gains, risk-seeking for losses.

• Emotions are not always irrational: feelings such as fear, regret, pride and hope carry information and help people act quickly under uncertainty (Damasio's somatic marker hypothesis).
• Regret theory: people anticipate regret and avoid actions that could cause it — leading to inaction or following the crowd.
• Affect heuristic: good feelings about a company (brand love) lead to judging it as low-risk and high-return.
• Reasoned emotions combine feelings with reflection — investors who recognise emotions can use them as signals while guarding against impulsive decisions.