BEHAVIOURAL FINANCE

​TERM PROJECT

An Entrepreneurial start-up developing a retail financial product

​CLIENT: Venture Capitalist

​Submitted To: Prof. Suveera Gill

Submitted By: Pooja Miglani
Roll No: 22
Course: M.com(H)
University Business School,
Panjab University, Chandigarh

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TABLE OF CONTENTS

INTRODUCTION 3

Behavioural Finance: 3
Behavioural Bias: 3
An Entrepreneurial startup: 4
Venture Capitalist(VC): 5

DESCRIPTION OF BEHAVIOURAL BIASES AFFECTING INVESTMENT DECISION OF THE

VENTURE CAPITALIST 5
Behavioural biases leading to observed behaviour: 5
Why market forces may not act to eliminate the biases? 7
PROPOSED STRATEGY FOR CORRECTING THE BEHAVIOURAL BIAS OF THE
VENTURE CAPITALIST 8
WHY SHOULD THE STRATEGY SUCCEED? 9

WHY SHOULD THE STRATEGY FAIL? 10

CONCLUSION 10

REFERENCES 11

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INTRODUCTION

Behavioural Finance:

It is a field of study that utilizes psychology to understand how investors make financial
decisions, both individually and as a whole, while challenging
(1) The rationality
(2) self-interest
(3) perfect information of traditional economic theory.
The field of Behavioral Finance asserts:
1). Rather than “rational,” human behavior is driven by fear and greed.
2). Rather than “self-interest,” people can be self-destructive, charitable, religious, and be
inclined to volunteer to help others.
3). Rather than “perfect information,” people today are exposed to virtually an infinite amount of
information, and often do not read the most relevant or important market data.
Behavioral Finance helps us explain actual investor and market behavior vs. theories of investor
and market behavior.

Behavioural Bias:

Bias is an irrational assumption or belief that warps the ability to make a decision based on facts
and evidence. Equally, it is a tendency to ignore any evidence that does not line up with that
assumption. A bias can be conscious or unconscious. When investors act upon them, they fail to
absorb evidence that contradicts their assumptions.
Psychologists have identified a number of types of bias that are relevant to investors:
● Representative bias leads to a snap judgment on a question based on its apparent
similarity to an earlier matter.
● Cognitive dissonance leads to an avoidance of uncomfortable facts that contradict one's
convictions.
● Home country bias and familiarity bias lead to an avoidance of anything outside one's
comfort zone.
● Mood bias, optimism (or pessimism) bias, and overconfidence bias all add a note of
irrationality and emotion to the decision-making process.

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 ● The endowment effect causes people to over-value the things they own just because they
own them.
● Status quo bias is resistance to change.
● Reference point bias and anchoring bias are tendencies to value a thing in comparison to
another thing rather than independently.
● Mental accounting is an irrational attitude towards spending and valuing money.
● The disposition effect is the tendency to sell investments that are doing well and hang
onto losers.
● Attachment bias is a blurring of judgment when one's own interests or a related person's
interests are involved.

An Entrepreneurial startup:

The term startup refers to a company in the first stage of its operations. Startups are founded by
one or more entrepreneurs who want to develop a product or service for which they believe there
is a demand. These companies generally start with high costs and limited revenue which is why
they look for capital from a variety of sources such as friends & family, angel investors and
venture capital etc.
In modern entrepreneurship, “funding” is mentioned so often that it almost seems like a required
step in the process. New companies, particularly companies that are developing brand-new
products, often don’t have customers or revenues when they start. These startups need money for
product development, and to support the company’s operations until revenues (sales) pay the
bills. Often, the more innovative the product, the longer it will take to develop, or to reach a large
market. So a new company needs money to develop and survive during this innovation startup
period.
In this assignment, an entrepreneurial start up developing a retail financial product is
reaching out for a ‘venture capital’ source of finance for raising funds for its business.
Venture Capitalist is the client of this entrepreneurial startup.
The scope of assignment includes the behavioural biases which may affect the investment
decision of the venture capitalist for this startup and how an entrepreneur can exploit/correct
the behaviour of the venture capitalist through his proposed strategies.

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Venture Capitalist(VC):

A venture capitalist (VC) is a private equity investor that provides capital to companies
exhibiting high growth potential in exchange for an equity stake. This could be funding startup
ventures or supporting small companies that wish to expand but do not have access to equities
markets. Venture capitalists are willing to risk investing in such companies because they can
earn a massive return on their investments if these companies are a success. VCs experience high
rates of failure due to the uncertainty that is involved with new and unproven companies.
In traditional finance theory, the investors are expected to be rational decision-makers going
along with the expected utility theory. Behavioral finance, in contrast to this, criticizes this
rational perspective and they argue that the investors tend to deviate from rationality whenever
they have to make investment decisions. Several behavioral biases that may occur in investment
decision making have been studied and empirically tested over the history. In the 1980’s,
behavioral finance emerged as a new concept combining behavioral and psychological aspects in
economic and financial decision-making.
Behavioral finance challenges the efficient market perspective and helps to understand why
investors behave in a particular manner while investing in financial assets.
According to various researches, it has been found that investors don't always take rational
decisions, their investment decision making is affected by several behavioural biases because of
the pressures and uncertainties which investors face while making decisions.

DESCRIPTION OF BEHAVIOURAL BIASES AFFECTING INVESTMENT

DECISION OF THE VENTURE CAPITALIST
Behavioural biases leading to observed behaviour:
Most of the top researchers in the field have focused on behavioural biases such as
overconfidence, disposition effect, herd behavior and home bias etc. Cognitive bias of venture
capitalists are considered in the assignment which leads to the observed behavioural anomaly.
As we know that, fundraising through venture capital is extremely difficult to secure. In the
world of entrepreneurship, venture capital investments are viewed as the Holy Grail of
fundraising, being referred to as “black swan” events because they are a rare phenomenon for
entrepreneurs.

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Venture capitalists (VCs) are very selective with their portfolios, only choosing ventures of the
highest caliber. It appears that investors have everything under control, exerting confidence in
their decisions as they hit consistent home runs. But, empirical research has shown extremely
challenging and costly cognitive biases that must be battled to make sound decisions.
Cognitive biases are defined as “thinking patterns based on observations and generalizations
that may lead to memory errors, inaccurate judgements, and faulty logic.
Following cognitive bias affects the decision making of a venture capitalists
1) Local Bias: ​This bias comes from a geographic similarity known as local bias. Local bias
is defined as the “average geographic distance between the VCs and their investment.”
Generally VCs have desired to have quick and easy access to information. Accessible
information increases a sense of familiarity with the ventures. When entrepreneurs come
from unfamiliar territory, it is more likely for investors to decline deals. VCs who feel
familiar with entrepreneurs tend to feel more comfortable, and one particular study also
shows that, being familiar with the entrepreneur or team can influence the investor to
decide in favor of the deal.
2) Similarity Bias: ​It is defined as the tendency to categorize people as being similar to
oneself, even when meeting them for the first time. According to one study on similarity
bias, there are two distinct dimensions that affect an investor’s decision: education and
work experience. Entrepreneurs will be categorized as similar if they have gone to the
same school, worked at the same company or shared a parallel experience as the investor,
which means they may have a benefit due to the favoritism that is caused by the bias.
People feel more comfortable when they can relate to others who share similarities.
Investors are one of those people. Researchers have also found that when investors feel
similarities to the entrepreneurs and startup teams, they evaluate the potential business in
a more favorable light.
3) Anchoring: ​A similar bias, known as anchoring, is the tendency to rely too heavily on
one factor or piece of information when making decisions. information processing bias,
where people use a default number or “anchor” and do not adjust adequately, and end up
using statistically arbitrary, psychologically determined anchor points. Investors may find
themselves focused heavily on one aspect of the venture because of past experiences,

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 causing them to view the deal through rose-colored lenses or worse and potentially
neglecting other aspects that balance the team or business model.
4) Information overload: ​Additionally, investors typically have to process large amounts
of data, for example analyzing technologies, teams, markets, trends, business models and
different types of risks. The massive amount of information provided to investors can
result in information overload. Research has found that the more information a VC
receives, the greater confidence investors will have in their decisions. More information
does not necessarily equate to better decision-making. Researchers have found that when
investors receive more information, they tend to believe they will make better decisions,
but more information simply increases confidence in the decision rather than accuracy.
As confidence increases with more information, the accuracy of the decision actually
decreases.

Why market forces may not act to eliminate the biases?

As we know that, Market results reflect the collective yet independent decisions of millions of
individuals.The efficient market theory relies on the idea that investors behave rationally and that
even when they don’t, their numbers are so great and their behavioral biases are so diverse that
their irrational behaviors will have little overall effect on the market. In effect, investors’
anomalous behaviors will cancel each other out. Also, Arbitrage is not always possible, due to
transaction costs and the risk of misinterpreting market mispricing.
Market inefficiencies can also persist due to economic and cultural factors such as:
1. lowered interest rates and increased use of debt financing,
2. new technology,
3. a decrease in government regulation or oversight,
4. demographic factors,
5. attitudes as reflected in popular culture,
6. the availability of information and its analysts,
7. the lowering of transaction costs,
8. increased participation in inefficient markets.

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PROPOSED STRATEGY FOR CORRECTING THE BEHAVIOURAL
BIAS OF THE VENTURE CAPITALIST

The strategy should be made in such a way that the venture capitalists can help the startup in
financing for its business without getting affected by those cognitive behavioural biases which
are explained above. An entrepreneurial firm must make him believe that he will get a reasonable
return on his investments. Entrepreneur may convince him that how the proposed strategy will
lead to the profitability of business and will provide him sufficient returns.
Local bias: If an entrepreneur is from unfamiliar territory, VC may get affected by ​local bias​,
there are chances of declining the deal in such cases. This generally happens because VC may
think that he may not easily get access to the required information from time to time.
Entrepreneurs can correct the local bias by making the VC ensure this concern. This can be done
through
➔ convincing the VC about the potential of his business, the clarity of the strategies, growth
path and business goals, the estimated time to earn profits and returns — all established
well in the business plan. The business presentation, placed to the investors, has to be
impressive, well-structured and supported by necessary data and documents to appeal
strongly to them. The entrepreneur thus needs to make a really good business pitch,
presenting a unique and interesting idea with all the information and data, clear business
strategies, properly defined growth path, targets and business goals — striking enough to
allure investors. He must create the right first impression in front of the VC.
Similarity Bias ​affecting the venture capitalist can be exploited by the entrepreneur. There is a
saying that “Birds of a feather flock together. The notion of similarity or dissimilarity between
start-up team and VC makes more sense with respect to personal characteristics than, e.g., with
respect to the start-up’s business model or industry. An entrepreneur can exploit the benefit of
this bias by working harder to broaden its network with the people or in the field to which the
VC belongs. He can convince the VC by creating a culture of belonging.
Anchoring Bias ​of the venture capitalists can be corrected by the venture capitalist. Anchoring
refers to the automatic process of identifying available information to provide a focal point or a
baseline for our judgement. A strategy can be made by an entrepreneur and it can be corrected:
➔ By identifying the factors behind the anchor and replacing suppositions with quantifiable
data.

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 ➔ Comprehensive research and assessment of factors affecting markets or a security's price
can be done to eliminate anchoring bias from decision-making in the investment process.
➔ Keep the VC updated with new information which is in his reasonable interest.
Information overload bias ​may affect the investment decision of the venture capitalists.
Generally, it is said that investors tend to finalize the deal when they are available with more
information but this is not the case, more information only increases the confidence in
information but doesn’t ensure accuracy and reliability. Therefore, an entrepreneur can work on
the strategy and correct this bias of VC by :
➔ Discerning the quality and quantity of information
➔ Helping investors see a clear and objective picture of the startup
➔ Communicating the novelty or proprietary quality of its product and its large market
potential
The ability to discern, distill and effectively communicate all the information about the business
can convince the investors to support the vision of an enterpreneur. This will help in increasing
confidence in the millions of dollars they could commit and lead an entrepreneur to realize its
startup’s big success story.
At last we can say that, an entrepreneur can take some strategic steps in order to correct/exploit
the various cognitive behavioural biases which leads to observed behaviour in their investment
decision making. Basically, Strategic aspects generally include all those steps which can ensure
the venture capitalists that the business idea of an entrepreneur is viable, profitable, sustainable
and also beneficial to society. If the venture capitalist is ready to finance the business, he must be
ensured of the reasonable returns which he’ll be earning through investing in an entrepreneurial
startup. Also, Entrepreneur should keep the VC updated of all the necessary material information
which may affect his investment decision.

WHY SHOULD THE STRATEGY SUCCEED?

➔ By identifying and understanding biases, systems, processes and tools can be developed
to provide a more objective lens to decision making.
➔ The world is rife with opportunities for disruptive startups to forever change entire
industries. When entrepreneurs in a global market infuse a validated business model with
venture capital, they can rapidly scale to become a billion-dollar brand.

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 ➔ Continual improvements to the business processes plays an important role in the success
of a startup.
➔ The basic litmus test that venture funds run on founders is whether a founder can get an
introduction to the fund through a network. Cold emails or stalking VCs is not a typical
way to get introduced. These days VCs expect founders to use their networks and get an
introduction. Building networks will help in getting this benefit.
➔ Explicitly defined and analyzed business criteria will help in getting favorable responses
from venture capitalists for raising funds for the business.

WHY SHOULD THE STRATEGY FAIL?

The strategy of an entrepreneur to exploit/correct the behavioural bias of the venture capitalist
might also fail due to the various risks and challenges involved.
➔ Unable to communicate the mission ​– Often businesses fail to deliver their intentions to
the venture capitalist. Being an external party, the Investor expects the business to
decipher the vision.
➔ Transparency – The most important of all is maintaining transparency throughout the
process. The business’s hesitation to share information breaks the confidence of venture
capitalists.
➔ Lack of clarity regarding usage of the fund​– Businesses need to have clarity regarding
the usage of prospective funding. Sometimes, an entrepreneur may fail to clear the
venture capitalist regarding usage of funds.
➔ Lack of innovative business model: ​Sometimes, entrepreneurs failed to impress the
venture capitalists for fundraising due to lack of innovation in their business model.
➔ Lack of Confidence: ​If an entrepreneur is not confident enough to engage the service of
the venture capitalist, he might fail in his strategy.

CONCLUSION

In this assignment, various cognitive behavioural biases of the venture capitalist who is a client
of an entrepreneurial startup are discussed and how these biases can affect their investment
decision making is explained through biases which lead to the observed behaviour of the venture

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capitalist. Four biases i.e Local Bias, Similarity Bias, Anchoring, Information overload bias are
considered and the strategy is proposed that how an entrepreneur can exploit or correct the
observed behaviour. Evidence supporting the strategy and various risks and challenges involved
due to which strategy might fail are also discussed in the last sections of the assignments. At last,
we can conclude that Because of the pressure and uncertainties investors face in making
decisions, these biases are especially important to understand, as any bias factor can be amplified
and become detrimental. Therefore, it is important for the entrepreneurs to understand how these
cognitive biases come into play and may provide leverage points for bringing ideas to fruition.

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​*THANKYOU*

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