2

Psychology:
Concept, Nature, Importance,
the Psychology of Financial
Markets and the Psychology
of Investor Behaviour

LEARNING OBJECTIVES
Explain the concept of psychology and cognitive psychology
Explain the nature of psychology
Describe the psychology of financial markets
Explain the psychology of investor behaviour

CONCEPT OF PSYCHOLOGY

The word, Psychology is derived from two Greek words, Psyche and Logos. Psyche
means soul and Logos means science. Thus, psychology was first defined as the
science of soul. In the 18th century, many psychologists started arguing that psychology
was the Science of Mind as it dealt with human brains. It is today seen as an applied
discipline to study the mental functions and behaviour of human beings. It systematically
explores human judgments and behaviours in different situations.

DEFINITION OF PYSCHOLOGY

The traditional definition of psychology is as follows:

Psychology as the science of mental processes by William James (1892).

Modern psychologists defined psychology as the Science of Consciousness. Some

definitions given by modern psychologists are as follows:

Psychology as the Science of the Inner World by James Sully (1884).

Psychology as the science which studies the internal experiences by Wilhelm
Wundt (1892).
Psychology as the Science of Behaviour by William McDugall (1905)
Science of behaviour and experiences on human beings by B.F. Skinner.
Psychology is the study of human behaviour and human relationship by Crow and
Crow.

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 12 Behavioural Finance

Psychology is the study of the mind and behaviour. The discipline embraces all
aspects of the human experiencefrom the functions of the brain to the actions of
nations, from child development to care for the aged. In every conceivable setting
from scientific research centres to mental healthcare services, the understanding
of behaviour is the enterprise of psychologists.
Source:http://www.apa.org/support/about/apa/psychology.
aspx#answer

The branches of psychology are as follows:

Social psychology
Behavioural psychology
Cognitive psychology

Social Psychology

Social psychology is the field of psychology which studies the behaviour of society as
a whole, considering the physiological and biological factors of society. For example,
studying the behaviour of children brought up in refugee camps.

Behavioural Psychology

Behavioural psychology is also known as Behaviourism. This field of psychology believes

in conditional learning of behaviour over a period of time.

Cognitive Psychology

Cognitive psychology is the systematic and scientific study of cognition, which is a

mental process which drives human behaviour. Cognitive psychology has special
importance in the field of behavioural finance, as it has its roots in this field. Cognitive
psychology describes the human thought at the stages of input, representation, processing
and output.
As shown in Figure 2.1, cognitive psychology is the driving factor at the stage of
representation of a thought that is uppermost in the mind. This representation varies from
person to person and so are the perception and the decision-making processes. Hence, the
way news or an event is processed varies and so also the output.

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 Psychology 13

Input Representation Processing 1 Output 1

Processing 2 Output 2

Processing 3 Output 3

Cognitive Psychology

Figure 2.1Stages of Human Thought in Cognitive Psychology

NATURE OF PSYCHOLOGY

Psychology as Science

There is consensus that the subject of psychology is a science as it is an objective study of

the human brain. In the process of attaining the objective, psychologists use experiments,
observations and various empirical evidences. This procedure of studying human behaviour
is quite similar to the systematic and scientific observations, measurements and analysis
of an event as in any field of science. In science, the objective is pre-identified in a set of
activities and so also is the case in the field of psychology. Hence, psychology is widely
accepted as science.

Psychology as Natural Science

Psychology is seen as a natural science because while dealing with human beings, the
psychologist needs to behave in his most natural manner. This behaviour should be
similar to the way a biologist deals with the subject. This is because if the subject under
consideration gets to know that he/she is being examined, the response is neither natural
nor genuine.

Psychology as Social Science

As psychologists deal with the study of human behaviour and society, psychology can be
justifiably called a social science. The relevance to studying psychology under the purview
of behavioural finance is because it is considered to be a social science.

Psychology as Positive Science

Normative science operates on logic or ought to be concept, whereas positive science

deals with facts as they are. Psychology, therefore, can also be called a positive science

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because it studies the behaviour of human being as it is and does not look at what it should
be. In behavioural finance too, we study the behaviour of financial markets and its players
(investors) what it actually is under certain conditions or mindset.

Psychology as Applied Science

Psychology deals with the application of its principles in observing the behaviour of
different individuals. As each individual is unique, the application of basic thoughts will
also be different in each case. This feature of psychology categorizes it as an applied
science.

IMPORTANCE OF PSYCHOLOGY

The importance of the study of psychology while taking investment decisions has been
discussed as follows:

To explore the concepts ofperception,cognition,attention, emotion,intelligence,

personality, behaviour, andinterpersonal relationships of investors dealing in stock
markets.
To explain how human beings differ from the way they are described by economists.
Identifying the behavioural biases that lead to market anomalies.
Understanding the psychology of investors will help their investment advisors to
provide investment solutions according to their clients personality. This will benefit
the advisory relationship of advisor with the client.
Study of psychology helps in maintaining and updating the investment portfolio to
generate better long term benefits.
Helps in understanding the behaviour of markets, which actually show the combined
effect of the investment activities of various investors. For example, explaining the
reasons for creation of bubbles.

PSYCHOLOGY WITH REFERENCE TO ECONOMICS

To understand the influence of psychology on economic transactions, let us go back to

the mid-eighteenth century when classical economics began including the study of human
behaviour for better understanding of economic decisions.
In economics, it is assumed that the investor will take the most rational decision,
which maximizes the Expected Value of Utility Function U(x). Under psychological
influences the expected utility becomes more realistic. Jeremy Bentham, a famous
thinker of his time, explained the principle of utility as approval or disapproval of
investors action according to the appearance of happiness to him. He further explained
that every action whatsoever seeks to maximize the utility. The concept of rational
economic man was also developed when the concept of maximizing the economic

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benefit remained in dominance. Later on, when the concept of maximizing of utility
was replaced by optimizing the utility, the importance of psychology in economic
decisions gathered attention. Now, the concept of Bounded Rationality explained that
the choices of investors are rational but these are subject to their knowledge and cognitive
capacity.

PSYCHOLOGY OF FINANCIAL MARKETS

The role of psychology in behavioural finance is self-evident. Its relevance has been
witnessed with reference to security market fluctuations and fluctuation in the mindset and
strategies of the investors.
In this section, we will discuss the anomalies and the fluctuations evident in the
financial markets worldwide.

Market Psychology

Market psychology is defined as the overall sentiment of the market. Optimism, pessimism,
fear, greed and various cycles of market are study areas of market psychology.
Market psychology works on the concept of behavioural analysis of financial markets,
which was proposed by James Gregory Savoldi. According to his observations and
evidences collected, the behaviour of financial markets happen to be quite different as it
is explained by various theories and models of traditional finance. Hence, to understand
the trends and behaviour of financial markets, inputs from the field of psychology and
economics were considered in traditional finance.
It is evident that financial markets move in trends (Bullish and Bearish), which are
actually outcomes of the greed and fear of the investors. Persistent greed leads to a
bullish trend whereas fear of fall in stock prices leads to a bearish trend. Psychologists
explain this tendency of greed and fear as investors emotions. If these human emotions in
financial markets are studied for a longer period, we can predict the future.

BOOM AND BUST CYCLES

Boom and Bust cycles are very prominent in financial markets. A very common example is
that of the Tech Bubble. Usually bubbles are created because of an extended boom period
which has to be followed by the bust of the same.
According to behavioural analysts, these cycles are repetitive and predictable in nature,
but the timing and duration is difficult to predict. Financial market history reveals that the
recovery from the bust of a bubble is far difficult and slower as compared to a normal cor-
rection. Again, the role of emotions is clear here, as investors lose trust which is difficult
to regain.

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OBJECTIVES OF BEHAVIOURAL ANALYSTS IN FINANCIAL MARKETS

The major objectives of an analyst in financial markets are as follows:

To understand the trend of financial markets of one specific economy.

To understand the behaviour of financial markets across the economies.
To understand the behaviour of financial markets as a longitudinal study.
To get an insight to the reasons of behaviour of financial markets.
To understand the psychology of various participants of financial markets.
To develop hedging strategies in financial markets which are becoming riskier and
more uncertain.

PSYCHOLOGY WITH REFERENCE TO INVESTORS

Psychology explores human behaviour by adopting various approaches. These approaches

are classified as follows:

Neurobiological Approach: The brain is considered the main driver of behaviour.

Behavioural Approach: The brain is considered as the black box that learns to
respond to stimulus given to it.
Cognitive Approach: In this approach psychologists argue that the stimuli given to
the brain is analysed and the response is given under the effect of various different
situations, which over a period of time develops ones personality.
Psychoanalytical Approach: It is based on various case studies of unconscious
mental activities.
Phenomenological/Humanistic Approach: It looks at human beings as Free
Agents who are free to choose their values, behaviour and actions.
Eclectic Approach: The incorporation of any of the above-mentioned approaches
is called eclectic approach.
While studying behavioural finance, we believe in the cognitive approach of psychology in
which the investors, whose behaviour is under observation will respond according to their
personality which are affected by different biases.
Psychology argues that investors preferences are based on their reference levels and
not the absolute levels of the outcomes of various decisions taken. Psychology also keeps
the capacity to give better explanation to the human errors committed towards making
efforts to maximize the expected value of utility function U(x). To understand the behaviour
of investors, we have categorized them into two:

Psychology of the Rational Economic Man

According to Neo-classical economics theory, the investor is Homo economicus. Homo

economicus are those investors who show perfectly rational behaviour and take economic

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investment decisions based on perfect information. In light of various forms of Efficient

Market Hypothesis, some researchers believed in the existence of a very high number of
rational economic traits in investors. These are those researchers who believe in the semi-
strong form of the EMH (discussed in Chapter 1).
Believers of the weak form of EMH believe that rational traits do occur, but not
predominantly. The belief in the existence of the rational economic man simplifies and
quantifies the observations of economists, but the major criticism faced by this concept is
because of the reasons mentioned as follows:

Doubt Regarding Existence of Perfect Rationality: Many psychologists have

argued that the behaviour of investors is also governed by human emotions. In
the real world, their decisions are not logical all the time but they are effected by
emotions like love, fear, hate, pleasure, etc. For example, even if we are offered
a good price for our ancestral property, we hate to sell the same. The decisions
of various investors to buy or sell at different levels are also an outcome of their
individual levels of satisfaction with the profit.
Doubt Regarding the Existence of Perfect Self-Interest: It is again a point of
debate that all the decisions taken by investors are for perfect self-interest. If this
would be so then the unselfish acts like NGOs, making donations, volunteering
activities, and others, would not exist.
Availability of Perfect Information: This is again evident that accurate and
relevant information is not available to all the investors at all the time. It is also
doubtful that perfect knowledge about the investment world is shown by all the
investors in the financial markets.
Hence, in light of the above discussion it is quite evident that investors are not perfectly
rational.

The Psychology of the Behaviourally Biased Investor

The objective to understand the psychology of investor behaviour should be to identify the
biases that can affect investor decision-making and to identify the factors that can influence
investor profiles. The instance of investors psychological irrationalities are categorized as
follows:

First, when investors make their own beliefs after perceiving any information
received in their own different ways.
Second, when they become overconfident about their actions.
Last, when they behave in an over-optimistic manner about the decisions taken.
All the aforementioned irrationalities make them trade too much and too often in stock
markets, which further leads to outcomes listed as follows:

Reduction in profits
Increased transaction costs

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Undiversified risks
Wrong analysis of available information
Irrational pace of financial markets toward an information.
The series of investors psychological irrationalities does not end here, but it further causes
instability in their preferences and leads to confused decision making.
Thus, with this discussion about investors psychology, it can be concluded that investor
behaviour is neither perfectly rational nor fully irrational but a combination of the two. The
dominance of different characteristics keeps changing with respect to different issues and
situations.

KEY LEARNING POINTS

Psychology is defined as an applied discipline to study the mental functions and

behaviours of human beings.
The various branches of psychology are social psychology, behavioural psychology
and cognitive psychology. Cognitive psychology is widely used in the field of
behavioural finance.
Psychology is considered as Positive Science, which explains the situations as
they are rather than what should be, which is a normative statement.
Psychology is important to understand human behaviour in different decision
making scenarios.
Cognitive psychology helps to explain investor behaviour and also the market
behaviour under the purview of behavioural finance.
Psychology of markets can be understood by the occurrence of different stages
(Bull and Bear) followed by each other and the creation of bubbles.
Psychology can also affect the explanation of Expected Utility U(x) and Bounded
Rationality.
According to psychology, the investors are of two typesHomo economicus and
behaviourally-biased investors.

REVIEW QUESTIONS

Long-Type Questions

Q1.Define psychology from the modern view point.

Q2.Explain the role of psychology in identifying investor behaviour in financial markets.
Q3.Differentiate between Homo economicus and Behaviourally Biased Investors.
Q4.Financial market cycles and bubble creations are outcome of human emotions. Justify.
Q5.Psychology is the science of mind. Comment.
Q6.Psychology plays an important role in finance. Explain.
Q7.Explain the scope of psychology in finance.

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Short-Type Questions

Q1.Define Homo economicus.

Q2.What are the objectives of psychology with reference to financial markets?
Q3.Explain the concept of bounded rationality.
Q4.Discuss the role of cognitive psychology in understanding the behaviour of financial
markets.
Q5.Psychology is a positive science. Justify.

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