Behavioural Finance Overview
Behavioural Finance is the field of study that combined insights from psychology and economics to explain how cognitive biases, emotional responses, and social influences caused investors to make systematic, predictable errors that deviated from the rational-actor model assumed by classical finance theory.
Classical finance theory — spanning Markowitz portfolio theory, the Capital Asset Pricing Model, and the Efficient Market Hypothesis — was built on the assumption of rational, utility-maximising investors who processed information correctly and made consistent decisions aligned with their long-run objectives. Behavioural finance, pioneered by Daniel Kahneman and Amos Tversky through a series of experiments beginning in the 1970s, demonstrated empirically that humans systematically violated these assumptions in predictable ways.
Kahneman and Tversky's 1979 paper Prospect Theory: An Analysis of Decision Under Risk (Econometrica) was the foundational document. It showed that people evaluated outcomes relative to a reference point (not absolute wealth), were roughly 2.5 times more sensitive to losses than equivalent gains, and applied non-linear probability weighting that overweighted small probabilities and underweighted large ones. Kahneman received the 2002 Nobel Memorial Prize in Economics; Tversky had died in 1996.
Subsequent research identified dozens of specific biases relevant to investment decisions: overconfidence (overestimating one's information quality and ability), anchoring (excessive reliance on an initial reference price), herding (following the crowd irrespective of independent analysis), recency bias (overweighting recent outcomes), availability heuristic (judging probability by how easily examples came to mind), and disposition effect (holding losers too long and selling winners too early).
In the Indian context, SEBI's investor education framework increasingly incorporated behavioural finance insights after 2015. AMFI's Mutual Funds Sahi Hai campaign implicitly addressed several biases — timing the market (driven by recency bias), stopping SIPs in downturns (loss aversion), and avoiding equity altogether (availability bias driven by salient crash memories). The campaign's emphasis on long-term, goal-based investing was grounded in behavioural research showing that pre-commitment mechanisms and automatic investment schedules reduced behavioural interference.
Academic research on Indian retail investor behaviour — using NSE and CDSL account-level data — documented the disposition effect, excessive trading, and loss-chasing in domestic equity markets, consistent with global behavioural finance findings. The SEBI F&O retail profitability study of 2023, showing over 90% of retail F&O traders losing money over three years, was partly explained through overconfidence, illusion of control, and gambler's fallacy biases documented in behavioural research.