Tipology : Encyclopedia
Category:   Financial system  

Abstract
Behavioural Finance is an approach to finance developed after the 1970s that uses studies in psychology and sociology of the behaviour of individuals and their underlying motivations to understand anomalies that occur in the capital market. This theory is based on the study of investor behaviour in situations of uncertainty that cause the individual to make incorrect and not always rational choices.

Figure 1 describes the fundamentals of Behavioural Finance. Psychology is the scientific study of behavioural and mental processes, together with how these processes are carried out by the physical, mental state and external environment of a human being. Sociology is the systematic study of human behaviour and social groups. This field focuses mainly on the influence of social relations on people's attitudes and behaviour. The classical paradigm of finance (Efficiency of Financial Markets) reached the pinnacle of success in academia in the 1970s, but much empirical evidence since the 1980s has cast doubt on its soundness, such as the excessive volatility of stock returns (Shiller 2003).

Fig. 1 The fundamentals of Behavioral Finance

Behavioural Finance offers a more realistic and humane interpretation of how financial markets work. The behavioural approach was first applied to financial markets to explain their anomalies on the one hand (Shiller 2003) and on the other to consider the set of emotions and feelings that influence market participants in making their investment choices and consequently market performance. It has since been applied to many other branches of economics and finance - but also to politics - such as behavioural corporate finance, macroeconomics, game theory, and so on.
Scholars of behavioural finance do not deny that there is efficiency in financial markets, but they argue that the adjustment of security prices to newly available information is far from being a quick and immediate process, characterised by a long phase during which arbitrage is possible before prices reach fair value.

Among the exponents who contributed substantially to the development of Behavioural Finance are psychologists Daniel Kahneman and Amos Tversky, who can be considered the true forerunners and those who made the greatest contribution to the subject by analysing how economic actors acted in evaluation and decision-making, paying attention to errors and choices under conditions of uncertainty. They demonstrated the strong loss aversion of investors in the face of risky alternatives, causing them greater displeasure than they are happy about a profit of equal magnitude. Daniel Kahneman and Vernon Smith were awarded the Nobel Prize in Economics in 2002 "for integrating results from psychological research into economic science, especially with regard to human judgement and decision theory under conditions of uncertainty".
Richard Thaler, Nobel laureate in economics in 2017, is considered a father of behavioural finance; he points out that there are two blocks of analysis, the first one moving from the presence of arbitrage in markets and the second one considering psychological distortions that limit the rationality of choices (Barberis and Thaler 2002). In the first block we can include those studies that have shown systematic errors in the markets, such as home bias, which consists in preferring investments in 'home' companies/securities over foreign companies/securities, in traders such as overconfidence, which consists in being overconfident in one's own abilities and information. In the second block, we can understand framing effects, such as loss aversion, which consists of feeling more pain at a loss than the pleasure of gain (see Barber and Odean 1999). Investors often adopt a non-rigorous approach (heuristics) in the choice and decision-making process and select information poorly; an example is the anchoring effect, which consists of making choices without considering real values.

Meir Statman and Hersh Shefrin have conducted important research in the field of behavioural finance. Statman (1995) wrote an extensive comparison between behavioural finance and traditional finance. According to Statman, individual behaviour and psychology influence investors and portfolio managers with regard to evaluative and decision-making processes in terms of risk assessment (i.e. the process of creating information regarding appropriate levels of risk) and framing issues (i.e. how investors make decisions based on how information is presented).

Shefrin (2000) describes behavioural finance as the interaction of psychology with the financial actions and performance of "professional traders". He advises that these investors should be aware of their own investment errors as well as of their counterparts' valuation errors.

An important development in behavioural finance relates to the mechanism by which investors use the information made available to them to make choices; Thaler and Sunstein (2009) explained how nudges
can be inserted "that alter people's behaviour in a predictable way, without prohibiting them from choosing other options and without significantly changing their economic incentives. To count as a mere goad, the intervention should be easy and inexpensive to avoid. Goads are not orders. Putting fruit at eye level on a shelf counts as a nudge. Prohibiting junk food does not".
Due to the role of authorities in consumer choice, the British government led by David Cameron in 2010 established the Behavioral Insight Team - Nudge Unit; this public benefit corporation studies cognitive distortions and works on persuasive messaging, judicious labelling of consumer products, setting information standards in health care, and personalised billing/billing.

From expected utility theory to prospect theory
Prospect Theory was developed by Kahneman and Tversky, who in the paper "Prospect Theory: An Analysis of Decision under Risk", (Kahneman and Tversky, 1979) analysed how investors systematically violate expected utility theory and highlighted the limitations of this theory by proposing an alternative model for analysing decision-making under conditions of uncertainty. The expected utility theory, devised by von Neuman and Morgenstern (1946), studies the economic behaviour of rational agents in situations of uncertainty, i.e. in situations in which the consequences of the decisions to be made are uncertain. According to this theory, it is indifferent for an individual to choose between events that have the same expected value, whether they are events with certain outcomes (100% probability of realisation) or events with random outcomes. The expected value of an event is obtained by multiplying each possible outcome of the event by the respective probability of realisation. For example, if a lottery gives as possible outcomes the realisation of profits for 10 or 20, with probabilities of 80% and 20% respectively, the expected value of the lottery is a profit of 12 calculated as follows: 10x0.8+20x0.2=12. According to expected utility theory, in this case it is indifferent for an individual to choose between the lottery with expected value equal to 12 and another with certain outcome equal to 12.

Kahneman and Tversky (1979) empirically analysed the choices of a sample of individuals to check for anomalies in their decisions that might contradict utility theory. When investors were asked to choose between a lottery offering a 25% probability of winning $3000 and a lottery offering a 20% probability of winning $4000, 65% of investors opted for the latter. Conversely, when subjects were asked to choose between a 100% chance of winning $3000 and an 80% chance of winning $4000, 80% chose the first hypothesis. It is evident that, based on the sample analysed, subjects tended to prefer an event that was certain (even if it offered winnings of a lower value) over an event that would only lead to a probable gain: this is the so-called certainty effect. In other words, individuals prefer to choose an event that would lead to a certain, even if lower, gain over an event that would lead to a probable, uncertain gain (even if higher expected value). They found, however, that individuals prefer events that lead to greater losses, but with lower probability of realisation over events that lead to smaller losses, but with higher probability, and speculatively prefer positive events that lead to a smaller gain, but with higher probability of realisation over positive events that lead to a larger gain, but with lower probability: this is the so-called mirror effect.

Individuals overestimate certain events, showing risk aversion in the case of positive events and risk appetite in the case of negative events. This different behaviour of individuals towards gains or losses is represented by the Value Function (Figure 2). The function indicates the individual's expected value in the presence of gains or losses and is a concave function in the positive domain and convex in the negative domain, where there is risk aversion. This means that individuals have a marginal sensitivity to changing gains and losses.

Fig. 2 The Value Function

From Figure 2, it can be seen that the curve increases less rapidly in the area of gains than it decreases in the area of losses. This happens because people evaluate gains and losses asymmetrically. According to Kahneman and Tversky, for individuals, the displeasure resulting from a loss is twice as great as the pleasure from a gain of the same amount. Another important result of the study by the two psychologists Kahneman and Tversky is the isolation effect: the individuals observed in the sample did not consider all elements of each alternative in the decision-making process, but only some, neglecting others in order to simplify the choice process.

Bibliography
BARBERIS N. and THALER R. (2002). A survey of behavioral finance. NBER working paper no.9222  https://www.nber.org/papers/w9222
KAHNEMAN D. and TVERSKY A., (1979). Prospect theory: An Analysis of Decision under Risk. Econometrica, Vol 47, No 2. pp. 263-292. The Econometric Society
ODEAN T. and BARBER B., (1999). The Courage of Misguided Convictions: The Trading Behavior of Individual Investors. Financial Analysts Journal, 1999 - Taylor & Francis
SHEFRIN H., (2000). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Oxford University Press
SHILLER R. J. (2003). From Efficient Markets Theory to Behavioral Finance. Journal of Economic Perspectives, 17 (1): 83-104. DOI: 10.1257/089533003321164967 http://www.econ.yale.edu/~shiller/
STATMAN M., (1995). Behavioral Finance vs. Standard Finance. Theory in Investment Management. Charlottesville, VA: AIMR: 14-22
THALER R. and SUNSTEIN C.. R. (2009). Nudge: The gentle push. Milan: Giacomo Feltrinelli Editore
VON NEUMANN J. and MORGENSTERN O. (1947). Theory of Games and Economic Behavior. Princeton, NJ, US: Princeton University Press

Editor: Chiara OLDANI (march 2025)