Question

Explain the importance of understanding emotions in financial decisionmaking and analyse clearly any 3 applications of behavioural finance to financial markets. Also discuss the underlying behavioural concepts in each of those applications

Answer 1

Emotions and understanding of emotions is very important in financial decision-making process because the market reflects the value perceived by the individual participants in the market rather than the financial fundamental derived values of the securities.

Traditional finance has many assumptions regarding the market and the market participants that are different from reality, and this difference is taken into consideration by the behavioral finance aspect.

The major points of differences in behavioural finance from traditional finance are:

1) Investors being considered normal instead of perfectly Rational

2) Investor have limits on self-control

3) Investors are influenced by their biases

4) Investors often make cognitive errors in decision making process

Application of these differences:

1) Hyperbolic Discounting

In simple terms it means giving more weightage to smaller recent gains than larger long term gains

2) Change in risk preference when associated with huge gain/loss:

People tend to go for a case with a very high gain with a very low possibility (example lottery) over the small (comparatively) price of participating in it, that is then turn risk loving. People also go for insurance when a high loss event is possible and pay premiums for coverage offered,they turn risk adverse. (An observation completely different from normal scenario of normal gain and normal losses)

3) Reference frame

Impact of any action (gain/loss) for any individual is shaped by how the individual reached at that state. For example a gain of $50,000 will be very different for 2 person, one having net worth of $100,000 and other having net worth of $1,000,000.

It is also observed that a loss of equal magnitude is more painful than the happiness from an equal magnitude gain