Fundamentals of Behavioural Finance and

Wealth Management
Vinay Dutta
Senior Professor in Finance
FORE School of Management, New Delhi
Three areas of discipline of finance
 Discussion Issue
?

How are the three areas of the discipline of finance interrelated?

Do they supplement and complement or compete with each other?
 Discussion Issue
?

In what ways conventional finance differ from behavioural finance?

 Behavioural finance
Behavioral finance is the study of how psychology
phenomena impact financial behaviour (Shefrin (2005)
It is a concept developed with the inputs taken from the
field of psychology and finance.

It tries to understand various puzzling observations in

stock markets with better explanations.

The behaviour of individuals, practitioners, markets and

managers is sometimes characterized as irrational.

People in standard finance are rational. People in

behavioral finance are normal. (Meir Statman)
 Traditional Finance versus Behavioural Finance
Traditional finance is based on the
assumption that human beings
(investors) are rational creatures,
risk averse, self-interested utility
maximizers, unbiased and invested
in optimal portfolios(mean-variance
efficient)
As per behavioural finance human
beings act as rationally as possible,
while recognizing that they are
constrained by a lack of knowledge
as well as a lack of cognitive ability
(Bounded rationality-Simon).
Rather than optimize, investors
satisfice-minimum course of action
to achieve goal.

Markets are: (i) efficient-prices Markets are based on observed

incorporate all available market behavior. Real financial
and relevant information, and markets don't resemble textbook
(ii) based on idealized markets that models are based on
financial behavior (Thaler)
 Traditional Finance versus Behavioural Finance
Prescriptive
Traditional finance (modern portfolio
theory) explains how investors should
act based on mathematical models and
theories
Descriptive
Behavioral finance attempts to explain
how investors actually act and increase
understanding of the reasoning patterns
of investors, including the emotional
processes involved and the degree to
which they influence the decision-
making process. Essentially, behavioral
finance attempts to explain the what,
why, and how of finance and investing,
from a human perspective.
Behavioural finance says that human
beings are prune to a number of
behavioural errors/biases, which affect
their performance in the financial
markets.
 Behavioral finance

In traditional finance, all investors are assumed to possess

the same information and interpret it accurately and
instantly, without bias, in evaluating investments and in
making utility-maximizing decisions.

Behavioral finance acknowledges that investors do not

always make decisions consistent with this form of utility
maximization.
 Bounded Rationality

Bounded rationality assumes knowledge capacity limits

and removes the assumptions of perfect information, fully
rational decision making, and consistent utility
maximization.

Individuals instead practice satisfice. Outcomes that offer

sufficient satisfaction, but not optimal utility.

Bounded rationality relaxes the assumptions of perfect

information and maximizing expected utility.
 Do you think Jatin’s behavior consistent with that of a
rational economic man ?

Jatin Batra has excess funds that he can deposit to earn

interest. He wants the funds to be backed by the
government, so he visits the bank closest to his
residence. The rate seems acceptable, and he makes the
deposit after verifying that the deposits are government
insured.
Do you think Jatin’s behaviour is consistent with that of a
rational economic man ?

No. Jatin is showing bounded rationality and satisfice.

The rate was adequate and met the condition of
government guarantee, so he accepted it. He did not
research all other options or have perfect information
(bounded rationality). There is no reason to expect that
this particular rate is the optimal solution.
 Branches of behavioral finance

Macro behavioural finance -Focuses on explaining how

and why markets deviate from what we would term
efficient in traditional finance. This deals with the
drawbacks of efficient market hypothesis.

Micro behavioural finance- Concerned with describing the

decision-making processes of individuals. In this the
irrational investors are compared to rational investors
(also known as homo economicus or rational economic
man) .
 Behavioral finance- Science and/or Art

Behavioral Finance as a Science

Science is a systematic and scientific way of observing,

recording, analyzing and interpreting any event.

Behavioural Finance has got its inputs from traditional

finance which is a systematic and well designed subject
based on various theories.

On this basis behavioural finance can be said to be a

science
 Behavioral finance- Science and/or Art
Behavioral Finance as an Art

In art we create our own rules and not work on “Rules of

Thumb” as in science. Art helps us to use theoretical
concepts in the practical world.

Behavioural finance focuses on the reasons that limit the

theories of standard finance and also the reasons for
market anomalies created.

It provides various tailor made solutions to the investors to

be applied in their financial planning.

Based on above behavioural finance can be said to be an

art of finance in a more practical manner.
 Prospect theory
Central to behavioral finance is Kahneman and Tversky’s
(1979) Prospect theory, a descriptive theory of decision
making in risky situations. This theory holds that:

Investors are more concerned with losses than gains,

assigning more significance to avoiding loss than to
achieving gain (loss aversion). Investors will increase risk
in order to avoid a feared loss.

Individuals are concerned more with changes in wealth

than adjustments in levels of wealth; and,

While utility theory assumes risk aversion, prospect

theory assumes loss aversion
 Prospect Theory

Above chart depicts a asymmetric value function. This

function is a representation of the difference in utility
(amount of pain or joy) that is achieved as a result of a
certain amount of gain or loss. In other words, losses are
weighted more heavily than an equivalent amount of gains.
 Prospect Theory

Example: Framing the decision as a gain or loss

Portfolio Assets Current Price Cost Basis Yesterday's Close Year-end Close

A 10 7 11 19
B 12 13 13 13
C 14 9 15 13

Which asset has the largest percentage loss?

 Prospect Theory

Answer: Example: Framing the decision as a gain or loss

It depends on the selected (framed) reference point to

determine perceived loss. A perception can affect
subsequent decisions. For example, if yesterday's close is
the reference point, every asset has a perceived loss with
Asset A having the largest percentage loss. However, if cost
basis is the selected reference, then B has the largest
percentage loss while A and C have gains.
Summary of Traditional Finance versus Bounded Rationality
and Prospect Theory

Traditional Finance Assume Bounded Rationality* and Prospect

Theory**Assume:

Unlimited perfect knowledge Capacity limitations on knowledge*

Utility maximization Satisfice*

Fully rational decision making Cognitive limits on decision

making*

Risk aversion Reference dependence to

determine gain or loss leading to
possible cognitive errors
 Wealth Redefined

Condition of well-being
 Wealth Creation

Logarithmic Utility of Wealth Logarithmic Utility of Wealth

Wealth (in Rs lakh) Utility 5

1 0 4.5

2 0.6932 4

3 1.0987 3.5

5 1.6096 3

Utility
7 1.9461
2.5
Utility
2
10 2.3028
1.5
20 2.9960
1
30 3.4016
0.5
50 3.9124 0
100 4.6056 0 10 20 30 40 50 60 70
Wealth in Rs lakh
80 90 100

What can you infer from above table and chart?

 Wealth Creation

What can you infer from above table and chart?

• Notice that the slope gets flatter as wealth increases.

• For a person with this utility function, added wealth at low

income levels increases utility more than added wealth at
high income
 Relationship between Goddess Lakshmi, Saraswati and Parvati

• Goddess Lakshmi symbolizes wealth

• Goddess Saraswati is synonymous with learning (knowledge)
and eloquence (expressiveness, persuasiveness,
articulateness)
• Goddess Parvati is synonymous with power (shakti), gives life
energy to think, link, see, hear, walk…

Wealth, Health and Learning are intertwined

Carefully, comprehend the word Learning (L+ Earning). Earning

is embedded into Learning.

“Learning never exhausts the mind.” (Leonardo da Vinci)

KEY to Learning
K-Keep E-Educating Y-Yourself (Be a life long learner).
 Money Redefined

M Materialistic orientation

O Obsession for possession

N Networking
E Emotions, Engagement and Enjoyment

Y Yield optimization
 Income versus Wealth

Accumulating wealth— as distinct from just making a big

income — is the key to your financial independence. It
gives you control over assets, power to help shape the
corporate and political landscape, and the ability to ensure
a prosperous future for your children and their heirs...

rev. jesse l. jackson, sr. and jesse l. jackson, jr.,

it's about the money!

Income is a flow, wealth is a stock

 The Road Map to Financial Freedom

Financial Freedom

the ability to live the lifestyle you desire without having to

work or rely on anyone else for money.
T. Harv Eker

But how does the seed of financial freedom take root?

 The Road Map to Financial Freedom

Learning
Financial freedom begins not in a Bank or
even in financial planner’s office but in your
mind
Pursuing your passion is fulfilling
and leads to financial freedom

Money memories, good or bad, have

astounding hold on our lives and impact
each one of us whether or not we deal with
money in a healthy way
 Personal financial planning

In the context of personal finance, it is a process

through which an individual or a family can chart a
roadmap to meet expected and unforeseen needs in life
for seeking financial freedom
 Why personal financial planning ?

Inflation i.e. a rise in the general price level is one of

the major factors that necessitates financial planning
For example
Your living expenses are Rs. 30000 at present, it would be Rs.
31,500 a year from today, assuming that prices rise at 5%. over
a 30 year period, you will be requiring Rs.129,600 to maintain
the same life style

Inflation is taxation without legislation

-Milton Friedman
 Why personal financial planning?

Changing life styles. financial planning aids

individuals both upgrade and maintain their life styles
For example
With higher disposable income, it is common for individuals
to upgrade their standard of living. Objects like cars, ACs
that were considered luxuries not too long ago, have become
necessities today.
 Why personal financial planning?

Changing life styles…

Money and lifestyle are major drivers of career change

More than half of Indian workers expect to switch

careers within the next five years due to money &
lifestyle issues, according to a latest survey by Kelly
Services.
Source: www.kellyservices.com
 Why personal financial planning?

Helps meet contingencies like medical

emergencies and unplanned expenditures

Contingencies are not a matter of “if”,

but rather “when”
 E’s (ease) of Money
and Wealth Management
 Wealth and Happiness
Money might buy interesting experiences, but researchers say cheap thrills
create happiness. Some of the happiness inducing choices that do not cost
anything at all
Discussion Issue

?
Money miser (Kanjus)

versus

Money wiser
 Money miser (Kanjus)

Accumulate wealth, hoards possessions, but enjoys watching

wealth, often living miserably

Usually a miser is reluctant to spend money, sometimes to the

point of forgoing even basic comforts and some necessities. A miser
gets emotional satisfaction or a feeling of enhanced security from
not spending money

Money wiser

Accumulate wealth, engage with wealth and enjoys wealth

Life Stages from Personal Wealth’s Perspective
 Components of Personal Wealth Management
CONTROLLING YOUR
FINANCIAL FUTURE

PLANNING YOUR
RETIREMENT AND PERSONAL FINANCES
ESTATE PLANNING OBTAINING
INVESTING YOUR
FINANCIAL RESOURCES

INVESTING
PLANNING

INSURING YOUR
RESOURCES MANAGING RISK SAVING

BORROWING

SPENDING

MANAGING YOUR
PERSONAL FINANCES
MAKING YOUR PURCHASING
DECISIONS
 Discussion Issue
?
The Perils of Procrastination
 Solution to the Perils of Procrastination

The Power of Pre-Commitment

The P’s of Pre-Commitment:

• Perfect planning and preparation
• Preventing poor performance

Planning and preparing when we are in rational state of

mind, followed by gathering information, analysis and
action plan
 The Power of Pre-Commitment

There are clear psychological challenges to maintaining a

clear head during a sharp sell-off. One way Uncle John
used to handle this was to make his buy decisions well
before a sell off occurred. During his years managing the
Templeton Fund, he always kept a “wish list” of securities
representing companies that he believed were well run but
priced too high…he often had standing orders with his
brokers to purchase those wish list stocks if for some
reason the market sold off enough to drag their prices
down to levels at which he considered them a bargain.

Source: Lauren C. Templeton, “Investing the Templeton Way”