Chapter 2

Psychology: concept,
nature and importance
 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
 PSYCHOLOGY: Concept
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.
Psychology is concerned with all aspects of
behaviour and with the thoughts, feelings, and
motivations underlying that behaviour. It keeps its
importance both as an academic discipline and a
vital professional practice.
 PSYCHOLOGY: Definition
Traditional definition of psychology
Psychology as the science of mental processes by William
James (1892).
Modern definition of psychology
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 Mc
Dugall (1905).
Science of behaviour and experiences on human beings
by B F Skinner.
PSYCHOLOGY: Branches
Social Psychology
Behavioral Psychology
Physiological Psychology
Applied Psychology
Educational 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 the society. For
example
Studying the behaviour of children
brought up in refugee camps
 Behavioral Psychology
Behavioral Psychology is also known
as behavioursim . This field of
Psychology believes in conditional
learning of behaviour over a period
of time
 Physiological Psychology
Physiological Psychology is a field
related to neurophysiology, which is
the study of relation between
behaviour and body system like the
nervous system and endocrine
system.
 Applied Psychology
& Educational Psychology

Applied Psychology:
Applied Psychology use the
knowledge gained from this research
in a wide range of settings. Applied
Psychologists help people with all
sorts of problems working with them
to bring about change with e sort of
problems working with them to bring
about change for the better.
 Educational Psychology

Educational Psychology
concentrates on those aspects of the
psychic activity that have to do with
learning.
 Cognitive Psychology
Cognitive Psychology revolves
around the notion of what makes
people think the way they do so and
also to figure out what processes are
actually going on their minds. The
main areas of study in cognitive
psychology are : perception
,attention ,memory and language.
The first ,perception is concerned
with the way a human being acquires
 The second ,attention ,is concerned with
acquisition .The third ,memory, is concerned
with organizing and retaining knowledge and
the final area ,language ,is concerned with the
knowledge is being used .
Perception,memory,speech and thinking are
the main subjects of this branch. The study of
emotion and the study of personality are two
related field that delve into the profound
questions of why we are different and why we
feel and how we feel.
 PSYCHOLOGY: Nature
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.
In science, the objective is pre-identified in a set of activities
and so also in the field of psychology.
Hence, psychology is widely accepted as a 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.
Psychology as Social Science
As psychologists deal with the study of human
behaviour and society, psychology can justifiably be
called 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 because it studies the behaviour of
human beings.

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.
 PSYCHOLOGY: Importance
To explore the concepts of perception, cognition,
attention, emotion, intelligence, personality,
behaviour, and interpersonal relationships of investors
dealing in stock markets.
To explain how human beings differ from the way
they are described by economists.
Identifying the behavioral biases that lead to market
anomalies.
Understanding the psychology of investors will help
their investment advisors
Study of psychology helps in maintaining and
updating the investment portfolio
Helps in understanding the behaviour of markets,
which actually show the combined effect of the
investment activities
 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.
 PSYCHOLOGY: FINANCIAL MARKETS

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 behavioral analysis
of financial markets, which was proposed by James Gregory
Savoldi.

BOOM AND BUST CYCLES

Boom and bust cycles are very prominent in financial markets. A
very common example is 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
analyst these cycles are repetitive and predictable in nature but
the timings and duration is difficult to predict.
FINANCIAL MARKETS: OBJECTIVES
OF BEHAVIOURAL ANALYSTS
To understand the trend of financial markets of one
specific economy.
To understand the behaviour of financial markets across
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
Neurobiological Approach
Behavioral Approach
Cognitive Approach
Psychoanalytical Approach
Phenomenological/Humanistic
Approach
Eclectic Approach
 Neurobiological Approach: The brain is
considered the main driver of behavior.
Behavioral 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 response is given under the
effect of various different situations,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
,behavior ,and actions.
Eclectic Approach : The
incorporation of any of the above-
mentioned approaches is called
eclectic approach
 Psychology: 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
investment decisions based on perfect information. In light of
various forms of Efficient Market Hypothesis (EMH)

Criticism faced by Efficient Market Hypothesis (EMH)

Doubt Regarding Existence of Perfect Rationality
Doubt Regarding the Existence of Perfect Self-interest
Availability of Perfect Information
Psychology: Behaviorally Biased
Investor
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
Undiversified risks
Wrong analysis of available information
Irrational pace of financial markets toward an information