Enigmatic Magic of Behavioural Finance

EducationWorld March 2022 | Magazine Spotlight Feature

– Prof. Ram B. Ramachandran, Professor of Practice and Vice Dean O.P. Jindal Global University

Mysteries of our brain have puzzled human beings for centuries. Neuroscientists and psychologists are still trying to figure out how 86 billion neurons and 100 trillion synapses work in tandem to compute, comprehend and rationalize. Our thoughts, emotions and memories are controlled by the enigmatic 3-pound brain. We make decisions in life sometimes based on empirical evidence and also based on our emotions and biases. We tend to magically create mental short cuts based on conscious and sub-conscious influences. It is specifically pronounced in financial decision making.

Financial markets are characterised by volatility, with prices moving in cycles of peaks and troughs. Lately, liquidity fuelled booms and busts have become common occurrences. In light of this, the assumptions of ‘Rationality’ and ‘Efficient Markets’ have been in dispute, but now it is widely acknowledged that much of this market volatility has its source in human behaviour and its quirks rather than fundamentals or quantitative factors. After all, what constitutes ‘markets’ if not their very human participants who make them up, technical trading strategies and algorithmic trading notwithstanding?

Analysing Emotions
It is becoming increasingly necessary to understand, analyse, and build strategies around human emotions to the extent they move financial decisions and markets. This is where Behavioural Finance comes in. The broader aim of Behavioural Finance is to narrow the gap between the theory of rational investor decisions and their actual behavioural abilities when it comes to making investment decisions. The formal study of Behavioural Finance helps to equip us with knowledge about the principles of psychology of decision-making under conditions of risk and uncertainty. This specialised knowledge can then be deployed to formulate practical applications for managing assets and constructing portfolios. The knowledge is specialised since it combines two domains that are not just technical (psychology/human behaviour and finance) but also as different as chalk and cheese! Thankfully, this niche field has received attention from serious academics from finance, economics and psychology.

Individual and Professional Investment
As Individual investors ‘suffer’ from behavioural biases, can they turn to professional investors? Well, professionals suffer from similar biases that afflict individuals. In fact, their biases many a time results in overconfidence, familiarity bias and disposition effect. Past performance is no guarantee for future results. Many investors and the markets rely on and follow ‘hot’ fund managers. The ‘hot-hand’ fallacy creates a self-fulfilling prophecy, which can then lead to wild swings when the fund manager goes ‘cold’. The current craze with cryptocurrency and Non-Fungible Assets (NFTs) are partially driven by crowd mentality. Can the wild swings in these new investment vehicles be better predicted and managed?

The need for Behavioural Finance
The need for such specialised knowledge is becoming obvious given how much finance and economics have gained from insights about psychological processes. Five Nobel Prizes in Economics have been awarded for path-breaking work on cognition, nudge theory, market behaviour and decision making, which now offers a deeper understanding of complex human behaviour.

The fundamental need for a structured Behavioural Finance course is driven by the fact that it can help us understand how financial decisions around investments, savings, risk and leverage, are influenced by human emotion and cognitive biases that affect how people react to events and information. Such insights are invaluable in building effective investment strategies. Institutional and individual investors can incorporate explanations for how bubbles like the dot-com era and the 2007 credit-fuelled boom occur (followed by the inevitable crashes), or even how corporate scandals like the ones at Enron, WorldCom, or Satyam Computer Services occur. After all, the only way to profit from market cycle or corporate events is to understand the fundamental theories and models that underpins these changes.

How Behavioural Finance studies help
A specialised Behavioural Finance course will help learners to:

Understand the cognitive elements that affect financial decisions
Identify the psychological factors that contribute to market behaviour and decision errors
Understand how to adapt the process of investment analysis, portfolio design, and resource allocation using principles from psychology
Manage financial risks in a better manner
Learn niche, specialised, and advanced topics in wealth management, financial analysis, risk management, neuro finance, etc.

Graduates of such specialised courses can also target professional opportunities in a wide range of areas of finance and investments such as analysts, traders, portfolio managers, etc., at pension funds, insurance companies, hedge funds, mutual funds, and family businesses.
Perhaps one way to understand the value of studying Behavioural Finance is that it helps us make more rational decisions by acknowledging our inherent irrationality and benefiting from that of others!

Programs Offered by JGU
O.P. Jindal Global University offers an innovative 2-year M.Sc. in Behavioural Finance program and 4-year integrated Ph.D. in Behavioural Finance. This unique and rigorous program combines Jindal School of Banking & Finance’s finance-focused and data intensive approach with Jindal Institute of Behavioural Sciences’ spirit of understanding psychological processes and human cognition.