Application of behavioral finance to the Indian context

Abstract

The field of behavioral finance is not new. Many investors have long considered that psychology plays a key role in determining the behavior of markets. However it is only in recent times that a series of concerted formal studies have been undertaken in this area. Amos Tversky and Daniel Kahneman’s papers on decision frames (1979) played a seminal role. The results of these studies were at variance with the rational, self-interested decision-maker posited by traditional finance and economics theory. Thaler (1993) defines behavioral finance as ‘simply open-minded finance’ claiming that ‘sometimes in order to find the solution to an [financial] empirical puzzle it is necessary to entertain the possibility that some of the agents in the economy behave less than fully rationally some of the time’. Thaler and Barberis (2002) also break down the field of study into two viz. Limits to arbitrage and Psychology. Limits to arbitrage claims that the market actions by irrational agents can cause dislocations which can persist as they cannot be undone by rational agents. Psychology on the other hand deals with the kind of irrationality displayed by agents and their effect on the market.