Behavioral Finance - Overview, Examples and Guide PDF

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he entire process of estimating return and risk for individual securities is known as Security Analysis.
Approaches to Security Analysis:
Traditional Security Analysis : Analysts have attempted to identify undervalued securities to buy, and overvalued securities to sell.
Modern Sec...

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1/23/22, 3:35 PM

Behavioral Finance - Overview, Examples and Guide

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Behavioral Finance How processing errors and biases impact investors

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Behavioral Finance

What is Behavioral Finance? Behavioral nance is the study of the inuence of psychology on the behavior of investors or nancial analysts. It also includes the subsequent eects on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are inuenced by their own biases. 

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Behavioral Finance - Overview, Examples and Guide

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Traditional Financial Theory In order to better understand behavioral nance, let’s rst look at traditional nancial theory. Traditional nance includes the following beliefs: Both the market and investors are perfectly rational Investors truly care about utilitarian characteristics Investors have perfect self-control They are not confused by cognitive errors or information processing errors Learn more in CFI’s Behavioral Finance Course! 

Behavioral Finance Theory Now let’s compare traditional nancial theory with behavioral nance. Traits of behavioral nance are:

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Behavioral Finance - Overview, Examples and Guide

Investors make cognitive errors that can lead to wrong decisions 

Decision-Making Errors and Biases Let’s explore some of the buckets or building blocks that make up behavioral nance. Behavioral nance views investors as “normal” but being subject to decision-making biases and errors. We can break down the decisionmaking biases and errors into at least four buckets. 

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Behavioral Finance - Overview, Examples and Guide

 Learn more in CFI’s Behavioral Finance Course!  #1 Self-Deception

The concept of self-deception is a limit to the way we learn. When we mistakenly think we know more than we actually do, we tend to miss information that we need to make an informed decision.  #2 Heuristic Simplication

We can also scope out a bucket that is often called heuristic simplication. Heuristic simplication refers to information-processing errors. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-finance/

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Behavioral Finance - Overview, Examples and Guide

emotion in behavioral nance refers to our making decisions based on our current emotional state. Our current mood may take our decisionmaking o track from rational thinking.  #4 Social Inuence

What we mean by the social bucket is how our decision-making is inuenced by others. 

Top 10 Biases in Behavioral Finance Behavioral nance seeks an understanding of the impact of personal biases on investors. Here is a list of common nancial biases. Common biases include: 1.

Overcondence and illusion of control

2. Self Attribution Bias 3. Hindsight Bias 4. Conrmation Bias 5. The Narrative Fallacy 6.

Representative Bias

7. Framing Bias 8. Anchoring Bias 9. Loss Aversion 10. Herding Mentality https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-finance/

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Behavioral Finance - Overview, Examples and Guide

biases.  #1Focus on the Process

There are two approaches to decision-making: Reexive– Going with your gut, which is eortless, automatic and, in fact, is our default option Reective – Logical and methodical, but requires eort to engage in actively Relying on reexive decision-making makes us more prone to deceptive biases and emotional and social inuences. Establishing logical decision-making processes can help protect you from such errors. Get yourself focused on the process rather than the outcome. If you’re advising others, try to encourage the people you’re advising to think about the process rather than just the possible outcomes. Focusing on the process will lead to better decisions because the process helps you engage in reective decision-making.  #2 Prepare, Plan and Pre-Commit

Behavioral nance teaches us to invest by preparing, by planning, and by making sure we pre-commit. Let’s nish with a quote from Warren Buett. “Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-finance/

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Behavioral Finance - Overview, Examples and Guide

Thank you for reading CFI’s guide on Behavioral Finance. To continue learning, these resources will be useful: Behavioral Finance Glossary Behavioral Interview Questions What is Financial Modeling? Types of Financial Models

Get Certied for Capital Markets (CMSA®) From equities, xed income to derivatives, the CMSA certication bridges the gap from where you are now to where you want to be — a world-class capital markets analyst. Learn More

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Behavioral Finance - Overview, Examples and Guide

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Behavioral Finance - Overview, Examples and Guide

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