Question

1) Define what is behavioral finance.

2) What's the difference between classical finance and behavioral finance

3) Explain what is anomaly in finance, and state two examples of annomaly

Answer 1

1) Define what behavioral finance is.

a. Behavioral finance defined as a study on human psychological behavior in terms of decision making in the field of finance.

b. Behavioral finance differs from tradition finance. Behavioral finance more focused on how the investors or individuals make decision with respect to finance in a given situation, which is mostly irrational and abnormal in nature.

c. Example: Mental Accounting, Overconfidence, Loss Aversion, etc.

2) What's the difference between classical finance and behavioral finance

a. Difference -

i. Classical finance assumes that the investor is rational and takes the decision on unbiased manner and without any emotional impact or under without any influence.

ii. Whereas the Behavioral finance decision are biased and non-emotional. The decisions are taken under the influence and biased based on information and irrational in nature

b. Example –

i. Investment to buy a stock based on it fundamentals analysis includes intrinsic value or asset valuation backed is the example of classical finance

ii. Investment decision taken based on past trend or current market trend, or any short terms information, which is biased, is an example of behavioral finance.

3) Explain what is anomaly in finance, and state two examples of anomaly

a. Anomaly in finance refers to deviation in actual result vs expected result. It is basically a difference between the expected state of result in the given scenario against the actual result which is abnormal in nature

b. Example –

i. Unexpected Earning declaration - Companies which gives unexpected earnings announcements is tend to move differently than those which announce within expectations

ii. Short Momentum – Based on historical trend certain stock outperforms without any change in fundamental value of the company is an example of anomaly.