Behavioral Finance Theory

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In the modern finance theory , behavioral finance is a new paradigm , which seeks to appreciate and expect systematic financial market influence of psychological decision making ( Olsen R A, 1998). In the recent studies irrationality in the decision making was revealed , based on certain cognitive limitations. The present chapter is divided into two aspects
According to traditional models in finance and economics, human beings are rational while taking their decision. However the recent studies explain that decision making is based on certain cognitive limitations. As the information’s are overloaded, we will be applying certain short cuts or heuristics in order to take a decision. The most important heuristics in the representativeness and anchoring. In the series of articles, Amos Tversky and Daniel Kahneman identified three key heuristics- namely representativeness, availability and anchoring- that potentially lead individuals astray. Anchoring explains as the indicator that people start with a benchmark value and adjust it in the obvious direction

STEP1 : INTRODUCTION TO BEHAVIORAL FINANCE
The aim of the first step of this thesis is to generate a conceptual idea about the concept of behavioral finance.
The concept of behavioral finance traced back over 150 years. However it emerged into the many academic journals ,business publications from 1990. Various scholars have various opinion regarding the evolution of Behavioral Finance . The famous derivation was made from Victor Ricciardi and Helon K Simon. (Victor Riccardi & Helen K Simon, 2000) defines Behavioral Finance as an interdisciplinary science derived from psychology, sociology and finance. Figure 1 demonstrates the important interdisciplinary relati...

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...irrationality of the investors. Later by integrating the psychological aspect Kahneman and Tverskey (1979) proposed Prospect Theory . Kahneman and Tverskey (1979) proposed the use of a psychological point of view in the well-known Prospect theory to explore the psychological behavior of investors, and the Value Function to replace the traditional expected utility theory. “Value Function” holds that a different attitude to risk prevails amongst investors when facing the prospect of either gain or loss. Facing gain, investors tend towards risk aversion to ensure the stability of profits. Facing the prospect of loss, investors choose to take more risk. Thus investors change their attitude to risk depending on the situation they face. However, in traditional financial theory, investors are considered to tend towards risk aversion at all times. (Shyan-Rong Chou, 2010).

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