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The IUP Journal of Behavioral Finance :
A Conceptual Framework of Behavioral Biases in Finance
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The behavior of financial markets and decisions of individuals are many a time driven by various biases. This can be attributed to the tendency of humans to resort to shortcuts owing to the constraints on time and mental capacity to process unlimited information. Various researchers have made an attempt to classify these biases into various types. But these biases have been viewed in isolation, thereby ignoring the possibility of any interaction or relationship between them. This paper aims to provide a comprehensive view of the behavioral biases by taking into account such interactions and developing a conceptual framework that incorporates the antecedents or causes of the biases and their outcomes or consequences. It also explores the possibility of overcoming some of the biases. It is argued that certain biases reinforce each other. The strength of each bias is a function of several factors like the external environment and presence of other biases in the process. The paper concludes that behavioral biases have been and will continue to influence human judgement. Although it is possible to avoid some of the biases in specific situations, it is not possible to completely eliminate them.

 
 
 

The field of behavioral finance has developed in response to the increasing number of stock market anomalies that could not be explained by traditional asset pricing models. Finance cannot be considered just as a science of numbers but it also involves the crucial human factor that drives the financial markets and decisions made by the individuals. Researchers have been attempting to explain various phenomena in finance and answering questions like: What drives the prices of the assets (which is many a times beyond their fundamental values) in the capital market? How do investors make choices or investment decisions? What are the biases that may affect their decisions? Can they behave irrationally at times? Why are some investors more risk averse and others more risk loving (i.e., the attitude towards risk)?

The functioning of the capital markets or money markets is not only dependent upon the availability of information (public or private) but also how the same information might be interpreted differently by different types of individuals (in this case the investors). In other words, the same set of information may be processed differently by different investors. This is one of the reasons why theories of efficient market which suggest that markets reflect all the available information and different asset pricing models sometimes fail to explain why prices or returns may deviate from the predictions of theories.

The individuals vary in their expectations about future state. For example, what are the interest rates expected to be after a certain period of time? Are the markets expected to rise or fall in the near future? Answers to such questions have led to the development of various theories of finance like the rational expectations hypothesis, liquidity preference theory, prospects theory, regret theory, etc. Various theories of financial intermediation and many others may also have derived their genesis inadvertently from behavioral aspects affecting the world of finance.

 
 
 

Behavioral Finance Journal, Asset Pricing, Contingent States, Capital Asset Pricing Model, Prospect Theory, Financial Literature, Bullish Market, Asymmetric Evaluation, Capital Asset Pricing Model, French Market, Political Crises, Asian Financial Crisis.