Development of Behavioural Finance - Essay Example

This was followed by Selden’s ground breaking work on the stock exchange where he attempted to explain people’s financial behaviour in the stock exchanges (Selden, 1912). Further work on behavourial finance continued through the efforts of psychologists such as Leon Festinger who introduced the concept of cognitive dissonance (Festinger et al., 1956). The more modern trends in behavourial finance were placed by Tversky and Kahneman who introduced the availability heuristic that delineated the financial probability of decision making by a person (Tversky & Kahneman, 1973).

This idea was followed by another expected utility theory that critiqued the original theory. This new theory delineated a descriptive model of decision making when faced with risks. The emerging model was espoused as the prospect theory (Kahneman & Tverksy, 1979). The prospect theory presented by Kahneman and Tversky has also been suggested as the alternative financial explanation for people making less than expected decisions in a risky market situation. The sixties saw the application of cognitive psychology to the processing of information by the brain.

This stood in contrast to behavioural models. The newly emerging cognitive models were being compared to each other such as those presented by Ward Edwards, Daniel Kahneman and Amos Tversky. This was augmented by the development of mathematical psychology that began to link up transivity of individual preferences to different kinds of measurement scales (Luce, 2000). These developments were augmented with the introduction of newer concepts such as overconfidence that forces individuals to make irrational choices which lead to poor financial decision making (Kahneman & Diener, 2003).

The bounded rationality projections in behavioural finance project that individuals act to maximise satisfaction rather than utility through their financial decision making even though it may lead to a loss (Gigerenzer & Selten, 2002) (Tsang, 2008). Over the years, various kinds of psychological traits like projection bias, overconfidence, limited attention and the like have been used in behavioural finance models. The domain of inter-temporal choice has also had various applications of behavioural finance which tend to use various kinds of psychological factors to explain basic models of rational choice.

Active Portfolio Management versus Passive Portfolio Management Fund managers carry out active portfolio management so that the portfolio investments tend to outperform a particular investment benchmark index. In contrast, fund managers who are not looking to outperform any investment benchmark index try to invest in funds that replicate previous weightings and returns. This technique is labelled as passive portfolio management (Malkiel, 1996). Passive portfolio management is the most preferred investment technique on the equity market but it is gaining wider acceptance in other investment fields.

The contention behind passive management is to reduce transactional costs as well as investment risks so that the investor’s output increases. In the modern economy it is common for funds to be managed with the original fund owners relying on fund managers to take investment decisions. According to Cuoco and Kaniel (2009), in 2004 the total amount of managed mutual funds exceeded $8 trillion, hedge funds totalled $1 billion and pension funds totalled more than $12 billion in the United States alone.

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