MODULE 1

INTRODUCTION TO BEHAVIORAL FINANCE:

EMH LIMITATIONS

Investors and researchers have disputed the Efficient Market Hypothesis both empirically
and theoretically. Behavioral economists attribute the imperfections in financial markets to
a combination of cognitive biases such as overconfidence, overreaction, representative bias,
information bias, and various other predictable human errors in reasoning and
information processing. The limitations of EMH include overconfidence, overreaction,
representative bias, and information bias.

1. OVER CONFIDENCE

 "No problem in judgment and decision making is more prevalent and more potentially
catastrophic than overconfidence".
Plous (1993)
 "People are overconfident. Psychologists have determined that overconfidence causes
people to overestimate their knowledge, underestimate risks, and exaggerate their ability
to control events. Does overconfidence occur in investment decision making? Security
selection is a difficult task. It is precisely this type of task at which people exhibit the
greatest overconfidence."
Nofsinger (2001)
 "Overconfidence is greatest when accuracy is near chance levels.
 Overconfidence diminishes as accuracy increases from 50 to 80 percent, and once
accuracy exceeds 80 percent, people often become underconfident. In other words, the
gap between accuracy and confidence is smallest when accuracy is around 80 percent,
and it grows larger as accuracy departs from this level.
 Discrepancies between accuracy and confidence are not related to a decision maker's
intelligence."

2. OVER REACTION

 investors overreact to negative news.‘

 ‗De Bondt and Thaler argued that investors overreact to both bad news and good news.
Therefore, overreaction leads past losers to become underpriced and past winners to
become overpriced.‘
 ‗De Bondt and Thaler predicted overreaction based on representativeness. [...] a portfolio
of extreme losers does outperform the market. However, a careful inspection of the figure
shows that the effect is concentrated in the month of January.‘
 ‗Fama argues that "apparent overreaction of stock prices to information is about as
common as under reaction.‘
 ‗Rather, what we find is apparent under reaction at short horizons and apparent
overreaction at long horizons.‘
 ‗What we seem to have is overreaction at very short horizons, say less than one month (L,
momentum possibly due to under reaction for horizons between three and twelve months
overreaction for periods longer than one year‘
 ‗The overreaction evidence shows that over longer horizons of perhaps three to five
years, security prices overreact to consistent patterns of news pointing in the same
direction.‘

3. REPRESENTATIVENESS BIAS

 When people are asked to judge the probability that an object or event A belongs to class
or process B, probabilities are evaluated by the degree to which A is representative of B,
that is, by the degree to which A resembles B.
 Representativeness has been replaced by attribution-substitution (prototype heuristic and
similarity heuristic).
 representativeness—according to which the subjective probability of an event, or a
sample, is determined by the degree to which it: (i) is similar in essential characteristics
to its parent population; and (ii) reflects the salient features of the process by which it is
generated. This heuristic is explicated in a series of empirical examples demonstrating
predictable and systematic errors in the evaluation of uncertain events. In particular, since
sample size does not represent any property of the population, it is expected to have little
or no effect on judgment of likelihood. This prediction is confirmed in studies showing
that subjective sampling distributions and posterior probability judgments are determined
by the most salient characteristic of the sample (e.g., proportion, mean) without regard to
the size of the sample. The present heuristic approach is contrasted with the normative
(Bayesian) approach to the analysis of the judgment of uncertainty."

4. Information Bias

 Information bias refers to bias arising from measurement error.[1] Information bias is
also referred to as observational bias and misclassification.
Evolution of Behavioral Finance:
―Homo Economicus ―was the first decision making model formulated in the19th century.
According to this model the investors are fully informed about investment options and
alternatives and the possible outcomes of their decision. According to ― homo economicus ―
investors are considered to Rational Economic Man (REM). With this assumption the financial
markets are considered to be efficient, economic agents who are rational and obey the axioms of
expected utility theory to make decisions. The finance theory was developed based on two
fundamental aspects: Rationality and Irrationality. In other words Standard finance and
Behavioral finance. Standard financé has two aspects: Traditional finance and Modern Finance.
The traditional finance explains the rationality of investor and decision making is based on
Expected Utility (EU) Hypothesis (Neumann & Morgenstern, 1944) . Where as in modern
finance, the underlying concept was maximizing the utility function of wealth based on informal
efficiency of market. Behavioral Finance In particular, there are two representative topics in
behavioral finance: -cognitive psychology and the limits of arbitrage (Ritter, 2002). Cognitive
psychology is the scientific study of human beings‟ cognition or the mental processes considered
to form human behavior. It explains the systematic errors made by the investors in the way they
take decisions in process of investment decision. The perspectives on the limits of arbitrage
predict the effectiveness of arbitrage forces under any circumstances. Behavioral Finance
suggests that there are ―limits to Arbitrage‖ as there exist investor behavior to buy the overpriced
and sell the underpriced securities in turn disturbing the parity condition in the short run because
of the risk perception (Ross, Westerfield, Jaffe, & Jordan, 2008). Many topics within the arena of
behavioral finance relate to cognitive psychology.

Difference between traditional theories modern theories and behavioral

finance.
Modern portfolio theory and behavioral finance represent differing schools of thought that
attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and
positions is to think of modern portfolio theory as how the financial markets would work in the
ideal world and behavioral finance as how financial markets work in the real world. Having a
solid understanding of both theory and reality can help you make better investment decisions.
Modern Portfolio Theory

Modern portfolio theory is the basis for much of the conventional wisdom that underpins
investment decision making. Many core points of modern portfolio theory were captured in the
early 1960s by the efficient market hypothesis put forth by Eugene Fama of the University of
Chicago. According to Fama‘s theory, financial markets are efficient, investors make rational
decisions, market participants are sophisticated, informed and act only on available information.
Since everyone has the same access to that information, all securities are appropriately priced at
any given time. If markets are efficient and current, it means that prices always reflect all
information, so there's no way you'll ever be able to buy a stock at a bargain price.

Other snippets of conventional wisdom include the theory that the stock market will return an
average of 8% per year (which will result in the value of an investment portfolio doubling every
nine years), and that the ultimate goal of investing is to beat a static benchmark index. In theory,
it all sounds good. The reality can be a bit different.

Enter Behavioral Finance

Despite the nice, neat theories, stocks often trade at unjustified prices, investors make irrational
decisions, and you would be hard pressed to find anyone who owns the much-touted ―average‖
portfolio generating an 8% return every year like clockwork. So, what does all of this mean to
you? It means that emotion and psychology play a role when investors make decisions,
sometimes causing them to behave in unpredictable or irrational ways. This is not to say that
theories have no value, as their concepts do work—sometimes.

Perhaps the best way to consider the differences between theoretical and behavioral finance is to
view the theory as a framework from which to develop an understanding of the topics at hand,
and to view the behavioral aspects as a reminder that theories don‘t always work out as expected.
Accordingly, having a good background in both perspectives can help you make better decisions.
Comparing and contrasting some of the major topics will help set the stage.

Market Efficiency

The idea that financial markets are efficient is one of the core tenets of modern portfolio theory.
This concept, championed in the efficient market hypothesis, suggests that at any given time
prices fully reflect all available information on a particular stock and/or market. Since all market
participants are privy to the same information, no one will have an advantage in predicting a
return on a stock price because no one has access to better information.

In efficient markets, prices become unpredictable, so no investment pattern can be discerned,

completely negating any planned approach to investing. On the other hand, studies in behavioral
finance, which look into the effects of investor psychology on stock prices, reveal some
predictable patterns in the stock market.
Knowledge Distribution

In theory, all information is distributed equally. In reality, if this was true, insider trading would
not exist. Surprise bankruptcies would never happen. The Sarbanes-Oxley Act of 2002, which
was designed to move the markets to greater levels of efficiency because the access to
information for certain parties was not being fairly disseminated, would not have been necessary.

And let‘s not forget that personal preference and personal ability also play roles. If you choose
not to engage in the type of research conducted by Wall Street stock analysts, perhaps because
you have a job or a family and don‘t have the time or the skills, your knowledge will certainly be
surpassed by others in the marketplace who are paid to spend all day researching securities.
Clearly, there is a disconnect between theory and reality.

Rational Investment Decisions

Theoretically, all investors make rational investment decisions. Of course, if everyone was
rational there would be no speculation, no bubbles and no irrational exuberance. Similarly,
nobody would buy securities when the price was high and then panic and sell when the price
drops.

Theory aside, we all know that speculation takes place and that bubbles develop and pop.
Furthermore, decades of research from organizations such as Dalbar, with its
Quantitative Analysis of Investor Behavior study, show that irrational behavior plays a big role
and costs investors dearly.

The Bottom Line

While it is important to study the theories of efficiency and review the empirical studies that lend
them credibility, in reality markets are full of inefficiencies. One reason for the inefficiencies is
that every investor has a unique investment style and way of evaluating an investment. One may
use technical strategies while others rely on fundamentals, and still others may resort to using
a dartboard. Many other factors influence the price of investments, ranging from emotional
attachment, rumors and the price of the security to good old supply and demand. Clearly, not all
market participants are sophisticated, informed and act only on available information. But
understanding what the experts expect—and how other market participants may act—will help
you make good investment decisions for your portfolio and prepare you for the market‘s reaction
when others make their decisions.

Knowing that markets will fall for unexpected reasons and rise suddenly in response to unusual
activity can prepare you to ride out the volatility without making trades you will later regret.
Understanding that stock prices can move with ―the herd‖ as investor buying behavior pushes
prices to unattainable levels can stop you from buying those overpriced technology shares.
Similarly, you can avoid dumping an oversold but still valuable stock when investors rush for the
exits.
Education can be put to work on behalf of your portfolio in a logical way, yet with your eyes
wide open to the degree of illogical factors that influence not only investors' actions, but security
prices as well. By paying attention, learning the theories, understanding the realities and applying
the lessons, you can make the most of the bodies of knowledge that surround both traditional
financial theory and behavioral finance.

Market Anomalies
Market anomalies are market patterns that do seem to lead to abnormal returns more often than
not, and since some of these patterns are based on information in financial reports, market
anomalies present a challenge to the semi-strong form of the EMH, indicating that fundamental
analysis does have some value for the individual investor. A market anomaly refers to the
difference in a stock‘s performance from its assumed price trajectory, as set out by the efficient
market hypothesis (EMH). EMH assumes that share prices reflect all of the information available
at any given time. In theory, this should make it impossible to purchase overvalued stocks, or sell
a stock above its value, because it would always trade at a fair market price.

Calendar effects

Calendar effects are a group of anomalies that occur at particular times or on particular dates
throughout the year. They are:
Monday effect

The Monday effect, also known as the ‗weekend effect‘, is the tendency of stock prices to close
lower on Mondays than on the previous Friday.

Many supporters of behavioural finance speculate that the Monday effect is caused by negativity
surrounding a new working week. But others believe that a more likely explanation of the
weekend effect is that companies often release bad news on Friday evenings, after the market has
closed. This would be supported by the tendency of investors to sell off their stocks on Friday
afternoons to avoid slippage over the weekend.

Turn-of-the-month

Turn-of-the-month refers to the pattern of a stock‘s value rising on the last day of each trading
month, with the price momentum continuing for the first three days of the next month.

Historically, the outsized gains at the turn of each month have a higher combined return than all
30 days in the month. There is little agreement about whether this is just a coincidence of random
behaviour, or the result of positive business news being more likely to be announced at the end
of the month.

January effect

The January effect describes the pattern of increased trading volume, and subsequently higher
share prices, in the last week of December and the first few weeks of January.

While it is also known as the turn-of-the-year effect, the term ‗January anomaly‘ is more
commonly used to refer to the tendency of small-company stocks to outperform the market in the
first two to three weeks of January.

It is believed that the January effect is caused by the turn of the tax calendar. Typically,
according to this theory, prices drop in December when investors sell off their assets in order to
realise capital gains. And, the increases in January are caused by traders rushing back into the
market.
Holiday effect

The holiday effect, or pre-holiday effect, is a calendar anomaly that describes the tendency for
the stock market to gain on the final trading day before a public holiday.

The most frequently cited explanation for this is that people are naturally more optimistic around
holidays, which can translate into positive market movement. An alternative explanation is that
short-sellers are more likely to close their positions prior to holidays.

The holiday anomaly can also be attributed to expectations that there will be volatility at these
times – the holiday effect becomes self-fulfilling, as traders buy or sell around the same
historical anomalies.

Post-earnings-announcement drift

The post-earnings-announcement drift is the name given to the pattern of stock returns
continuing to move in the direction of surprise earnings. This anomaly follows a company
announcement and is caused by the market gradually adjusting to new information.

In theory, if markets were entirely efficient, then company earnings announcements would cause
an immediate shift in prices as the report is instantly factored into the market price. However, in
practice, it can take up to approximately 60 days for markets to adjust – with a positive earnings
announcement causing an upward drift, and a negative earnings announcement causing a
negative earnings drift.

The most widely accepted reason for this delay is that markets under-react to earnings reports,
and so it takes a period of time before the information gets absorbed into the stock‘s price.

Momentum effect
The momentum effect is based on historical technical analysis that suggests recent stock market
‗winners‘ are more likely to continue to outperform the ‗losers‘ – or that stocks with a strong
upward trajectory are likely to continue to rise in the short to medium-term.

The momentum anomaly suggests that traders can take advantage of these price movements by
going long on winners and shorting the losers.

One of the popular explanations for the momentum effect is that markets do not immediately
price in new information, but do so more gradually.

Let‘s say a company releases good news, but buyers under-react and take a while to flood the
market, the price increase would be more gradual. This makes it appear that the winners are
taking consistent gains.

Value effect

Perhaps one of the most well-known fundamental anomalies is the value effect. This anomaly
refers to the tendency of stocks with below-average balance sheets to outperform growth stocks
on the market, due to investor belief in companies‘ potential.

Normally, if the market value is higher than the book value per share, a stock is considered
overvalued, while a stock with higher book value than market value is often thought of as
undervalued. While this would usually prompt the market to correct, the value effect sees traders
behaving counter to accepted practice and buying shares that are technically overvalued.

Although there is increased risk in investing in low-book-value stocks – as they could fall into
financial distress – it is weighed up against the potential for superior returns.
EQUITY PREMIUM PUZZLE

The equity premium puzzle refers to the inability of an important class of economic models to
explain the average premium of a well-diversified U.S. equity portfolio over U.S. Treasury Bills
observed for more than 100 years. The term was coined by Rajnish Mehra and Edward C.
Prescott in a study published in 1985 titled The Equity Premium: A Puzzle,[1][2]. An earlier
version of the paper was published in 1982 under the title A test of the intertemporal asset
pricing model. The authors found that a standard general equilibrium model, calibrated to display
key U.S. business cycle fluctuations, generated an equity premium of less than 1% for reasonable
risk aversion levels. This result stood in sharp contrast with the average equity premium of 6%
observed during the historical period. In 1982, Robert J. Shiller published the first calculation
that showed that either a large risk aversion coefficient or counterfactually large consumption
variability was required to explain the means and variances of asset returns.[3] Azeredo (2014)
shows, however, that increasing the risk aversion level may produce a negative equity premium
in an Arrow-Debreu economy constructed to mimic the persistence in U.S. consumption growth
observed in the data since 1929.[4] The intuitive notion that stocks are much riskier than bonds is
not a sufficient explanation of the observation that the magnitude of the disparity between the
two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level
of investor risk aversion that is fundamentally incompatible with other branches of economics,
particularly macroeconomics and financial economics. The process of calculating the equity risk
premium, and selection of the data used, is highly subjective to the study in question, but is
generally accepted to be in the range of 3–7% in the long-run. Dimson et al. calculated a
premium of "around 3–3.5% on a geometric mean basis" for global equity markets during 1900–
2005 (2006).[5] However, over any one decade, the premium shows great variability—from over
19% in the 1950s to 0.3% in the 1970s.

To quantify the level of risk aversion implied if these figures represented the expected
outperformance of equities over bonds, investors would prefer a certain payoff of $51,300 to a
50/50 bet paying either $50,000 or $100,000.[6] The puzzle has led to an extensive research effort
in both macroeconomics and finance. So far a range of useful theoretical tools and numerically
plausible explanations have been presented, but no one solution is generally accepted by
economists.

OVER REACTION & UNDER REACTION

https://www.fep.up.pt/conferencias/pfn2006/Conference%20Papers/577.pdf

DAY OF THE WEEK EFFECT

Anomalies can be described as unexpected price behavior in the market. The day-of-the-week
effect is one form of a seasonal anomaly and it is one of the most heavily investigated topics.
Early studies, like Cross (1973) and French (1980), have shown that there exists a negative
Monday effect, meaning essentially that mean returns on Mondays are negative. The existence of
this effect contradicts to the EMH, suggesting that there should be no observable pattern of
return in the market. Moreover, this could give investors a possibility to earn positive risk-
adjusted returns (RAR). More recent studies, like Steeley (2001) and Kohers et al. (2004)
suggests that the stock markets are more efficient today, causing the day-of-the-week effect to
slowly disappear. The day-of-the-week effect is an example of a calendar anomaly where the
daily mean return differs across the days of the week. According to the Efficient Market
Hypothesis, each daily mean return should be equal to each other:

Where R is the daily mean return.

ALLAIS AND ELLSBERG PARADOXES

Human beings crave certainty and loath ambiguity. People naturally gravitate towards the ―sure
thing‖ versus another option where the outcome is uncertain. Sometimes this is true even when
the uncertain path may have huge upside.
Take William Orton, who was the President of Western Union in the 1860s. Many credit him
with the worst business decision in history, a decision he made when faced with uncertainty
versus a more certain path available to him.

When Orton was running Western Union, it was a business focused on business
communications that tended to be short, and where reliability of transmission was paramount.
When Alexander Graham Bell pitched Orton on the idea of an ―acoustic telegraph,‖ Orton
dismissed the idea, since he viewed it as inconsistent with the required fundamental attributes of
the telegraph business; it was too radical an innovation, too difficult to commercialize.

Bell‘s invention eventually became, of course, the telephone, arguably the most significant
technological innovation of the 19th century. Orton fell victim to risk aversion. He was perhaps
influenced by the ―certainty effect,‖ which has been explored by academics.

Are you an effective decision maker? If you are like most people, you likely have a clear
head when making choices under explicitly commutable risks (i.e., risks that can be exchanged
for other risks), but may become less decisive when dealing with unknown risks and ambiguous
situations. Today we present three games to test how you make choices under uncertainty.

Game 1: Ellsberg paradox

The Ellsberg paradox is a famous example that highlights risk aversion. If you are not familiar
with the details, let‘s first look at the figures below.

There are two urns, and each contains 100 balls. The left urn contains 50 black balls and 50
white balls, and the right one contains white and black balls in an unknown proportion.

You have a bet to make. A ball will be randomly drawn from one of the two urns, and in each
numbered case below (numbered 1-4) you must make a choice between choice A, and choice B,
or you can choose to be indifferent between the choices.

1. Do you bet that: A) a black ball will be drawn from the left urn, or B) a white ball will
be drawn from the left urn?
2. Do you bet that: A) a black ball will be drawn from the right urn, or B) a white ball will
be drawn from the right urn?
3. Do you bet that: A) a black ball will be drawn from the left urn, or B) a black ball will
be drawn from the right urn?
4. Do you bet that: A) a white ball will be drawn from the left urn, or B) a white ball will
be drawn from the right urn?
Pic source unknown. Game source: http://shookrun.com/bf/bfaversiontoambiguity.htm

If you are like most people, you will choose: 1. indifferent, 2. indifferent, 3, A, and 4. A. Let‘s
examine each of these choices in turn.

Choices 1 and 2 seem straightforward. You will not necessarily better off by betting on either
black or white, if you‘re choosing from only the left urn, or only the right urn. With the left urn,
it‘s a 50/50 bet, hence there‘s no reason to prefer one over the other, and with the right urn, well
you just don‘t know the mix of black and white so it doesn‘t make sense to choose one here
either.

Choices 3 and 4 also seem to make sense independently. In both cases, you will prefer choosing
from the left urn, where the odds are 50/50, rather than choosing from the right urn, which could
be all black, all white, or some mix of the two.

Here is the paradox.

Imagine there is a third party, who is ignorant as to your knowledge of the contents of the right
and left urns. This third party wants to try to assess your views of the probabilities by
considering how you answered the questions.

This third party knows from the last 2 questions that: 1) you think black/left is more likely than
black/right, and 2) you think white/left is more likely than white/right.

But these cannot both be ―more likely‖ simultaneously. They cannot both be true. This is an
impossibility, as your subjective probabilities sum to something greater than one for the left urn.
Therefore, choosing A as the answer for both case 3 and 4 conveys no information about the
underlying probabilities in these cases. This third party can‘t make any judgments about the
actual probabilities based on your answers.

Game 2: the Allais paradox

The Ellsberg paradox highlights our natural aversion to risk. The Allais paradox demonstrates
what is known as the ―certainty effect,‖ whereby when a certain outcome is available, it
enhances this risk aversion.
Let‘s look at the two cases below:

 Case I: Uncertainty versus Uncertainty, which do you choose?

A: $100 million with a probability of 11%, or $0 with a probability of 89%.

B: $500 million with a probability of 10%, or $0 with a probability of 90%.

 Case II: Certainty versus Uncertainty, which will you choose?

C: $100 million with a probability of 100% certainty.

D: $500 million with a probability of 10%, or $100 million with a probability of 89%, or $0 with
a probability of 1%.

In case I, most people choose B, since B has higher expected return than A. In a situations with
one uncertainty versus another uncertainty (i.e., different degrees of risk), people tend to
maximize expected value.

However, In case II, most people choose C, even though the expected value is higher in D. Why?
People prefer the sure thing, even when an alternative may offer a superior expected return.
Although the extreme downside case of a $0 payout is highly unlikely, we would experience a
lot of regret if we lost, especially knowing we had forgone a chance to win with certainty.

Applications in Finance:

The Ellsberg paradox shows us that can depart from rational decision-making, as informed by
probabilities, since we are averse to ambiguity and avoid probabilities when they are difficult to
assess. As Frank Zhang pointed out, in a 2006 paper:

…the degree of incompleteness of the market reaction increases monotonically with the level of
information uncertainty, suggesting that investors tend to underreact more to new information
when there is more ambiguity with respect to its implications for firm value.

How might this be reflected in the market? We might favor preferred stock, with a dividend
stream that has payouts of specific, fixed amounts, over an investment in common stock with
more ambiguous payouts, including dividend increases and appreciation potential, which is hard
to assess. Such a preference may be unduly affected by our aversion to ambiguity, rather than by
a strictly rational assessment of each security, leading us to make the wrong decision.

The Allais paradox demonstrates that when faced with a ―sure thing,‖ we can sometimes
overweight its value relative to other opportunities, since the possibility of downside outcomes is
highly salient, and available to us. In other words, our concern about the possibility of a bad
outcome is not consistent with its probability; we overweight the risks when certainty is an
option.

Consider a tender offer from a firm. You bought the stock at $5, and it has traded up to $10, and
today, the company offers to repurchase your stock for today‘s $10. You have recently done
valuation research suggesting that the intrinsic value of the firm is actually $15. Yet, because you
have a ―bird in hand,‖ an offer to buy out your entire position at the $10 price, you conclude that
you want to sell. Why? I would be too painful to see the stock trade back down below $10 and to
have to sell at such a lower price, when you could have sold it at $10, which is a ―sure thing.‖ In
this case, you would be overemphasizing the downside risk, and discounting your own research,
since you have a certain outcome available to you, which is distorting your judgment.

Decision makers, like physicians, patients, equity investors, and so on, prefer certainty, rather
than complexity and ambiguity. This sometimes causes many decision makers to choose options
that contravene the expected utility of the problem. That is, the certainty Effect contributes to
risk aversion and will lead people make choices that inconsistent with expected utility theory.

MODULE 2
The behavioral foundations- Role of information processing.

Preferred Information processing

Intuitive and Dual processing

Bayesian information processing Framing

Framing bias occurs when people make a decision based on the way the information is
presented, as opposed to just on the facts themselves. The same facts presented in two
different ways can lead to people making different judgments or decisions. In behavioral
finance, investors may react to a particular opportunity differently, depending on how it is
presented to them. Framing Bias in Finance

The phrasing, or how an investment is ―framed‖, can cause us, as investors, to change our
conclusions about whether the investment is good or bad.

What‘s fascinating is that when investors are not sure of all the facts, or in a situation where
there are many unknowable factors, there is, in fact, a high probability of reflexive decision
making. The probability of being influenced by framing bias is, thus, also increased.
Below are some examples of framing in finance:

Option 1: ―In Q3, our Earnings per Share (EPS) were $1.25, compared to expectations of
$1.27.‖

vs.

Option 2: ―In Q3, our Earnings per Share (EPS) were $1.25, compared to Q2, where they were
$1.21.‖

Clearly, option 2 does a better job of framing the earnings report. The way it is presented – as an
improvement over the previous quarter – puts a more positive spin on the EPS number.

Mental Accounting
Mental accounting refers to the tendency people have to separate their money into different
accounts based on miscellaneous subjective criteria, including the source of the money and the
intended use for each account. The theory of mental accounting suggests that individuals are
likely to assign different functions to each asset group in this case, the result of which can be an
irrational and detrimental set of behaviors.

Many people use mental accounting. What these individuals may not realize, though, is that this
line of thinking is in fact highly illogical. For instance, some people keep a special ―money jar‖
or similar fund set aside for a vacation or a new home while at the same time carrying substantial
credit card debt. (For more insight, see Digging Out Of Personal Debt.)

In the example of the ―money jar,‖ individuals are likely to treat the money in this special fund
differently from money that is being used to pay down debt, in spite of the fact that diverting
funds from the debt repayment process increases interest payments, thereby reducing the
person‘s total net worth. Broken down further, it‘s illogical (and, in fact, detrimental) to maintain
a savings jar that earns little or no interest while simultaneously holding cred-card debt accruing
double-digit figures annually. Individuals in this scenario would be best off using the funds they
have saved in the special account to pay off the expensive debt before it accumulates any further.

Put in this way, the solution to this problem seems straightforward. Nonetheless, many people do
not behave in this way. The reason for this has to do with the type of personal value that
individuals place on particular assets. Many people feel, for example, that money saved for a
new house or a child‘s college fund is simply ―too important‖ to relinquish, even if doing so
would be the most logical and beneficial move.

Consider this example, which is designed to illustrate the importance of different accounts as
related to mental accounting: you have set for yourself a lunch budget for each week and you are
purchasing a $6 sandwich for lunch. As you go to buy the sandwich, one of the following events
takes place: 1) you find that you have a hole in your pocket and have lost $6; or 2) you buy the
sandwich, but as you go to take a bite, you trip and the sandwich falls on the floor. In either case
(assuming you still have enough money), does it make sense to buy another sandwich? (To read
more, see The Beauty Of Budgeting.)Taken logically, the answer to both scenarios should in fact
be the same, as it relates to your total weekly lunch budget.

Prospect Theory and its application in stock markets

Common sense might suggest that individuals combine the net effect of the gains and the losses
associated with any choice in order to make an educated evaluation of whether that choice is
desirable. An academic way of viewing this is through the concept of ―utility,‖ often used to
describe enjoyment or desirability; it seems logical that we should prefer those decisions which
we believe will maximize utility.

On the contrary, though, research has shown that individuals don‘t necessarily process
information in such a rational way. In 1979, behavioral finance founders Kahneman and Tversky
presented a concept called prospect theory. Prospect theory holds that people tend to value gains
and losses differently from one another, and, as a result, will base decisions on perceived gains
rather than on perceived losses. For that reason, a person faced with two equal choices that are
presented differently (one in terms of possible gains and one in terms of possible losses) is likely
to choose the one suggesting gains, even if the two choices yield the same end result.

Prospect theory suggests that losses hit us harder. There is a greater emotional impact associated
with a loss than with an equivalent gain. As an example, consider how you may react to the
following two scenarios: 1) you find $50 lying on the ground, and 2) you lose $50 and then
subsequently find $100 lying on the ground. If your reaction to the former scenario is more
positive than to the latter, you are experiencing the bias associated with prospect theory.

Evidence for Irrational Behavior

Kahneman and Tversky engaged in a series of studies in their work toward developing prospect
theory. Subjects were asked questions involving making judgments between two monetary
decisions that involved potential gains and losses. Here is an example of two questions used in
the study:

1. You have $1,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of gaining $1,000, and a $50 chance of gaining $0.

Choice B: You have a 100% chance of gaining $500.

2. You have $2,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.
 Choice B: You have a 100% chance of losing $500.

If these questions were to be answered logically, a subject might pick either ―A‖ or ―B‖ in both
situations. People who are inclined to choose ―B‖ would be more risk adverse than those who
would choose ―A‖. However, the results of the study showed that a significant majority of people
chose ―B‖ for question 1 and ―A‖ for question 2.

The implication of this result is that individuals are willing to settle for a reasonable level of
gains (even if they also have a reasonable chance of earning more than those gains), but they are
more likely to engage in risk-seeking behaviors in situations in which they can limit their losses.
Put differently, losses tend to be weighted more heavily than an equivalent amount of gains.

This line of thinking resulted in the asymmetric value function:

This chart represents the difference in utility (i.e. the amount of pain or joy) that is achieved as a
result of a certain amount of gain or loss. This value function is not necessarily accurate for
every single person; rather, it represents a general trend. One critical takeaway from this function
is that a loss tends to create a greater feeling of pain as compared to the joy created by an
equivalent gain. In the case of the chart, the absolute joy felt in finding $50 is significantly less
than the absolute pain caused by losing $50.

As a result of this tendency, during a series of multiple gain/loss events, each event is valued
individually and then combined in order to create a cumulative feeling. Thus, if you were to find
$50 and then lose $50, you‘d probably end up feeling more frustrated than you would if you
hadn‘t found or lost anything. This is because the amount of joy gained from finding the money
is outweighed by the amount of pain experienced by losing it, so the net effect is a ―loss‖ of
utility.
Financial Relevance

Many illogical financial behaviors can be explained by prospect theory. For example, consider
people who refuse to work overtime because they don‘t want to pay more taxes. These people
would benefit financially from the additional after-tax income, but prospect theory suggests that
the benefit they would achieve from earning extra money for additional work does not outweigh
the sense of loss they feel when they pay additional taxes.

The disposition effect is the tendency that investors have to hold on to losing stocks for too long
and to sell winning stocks too soon. Prospect theory is useful in explaining this phenomenon as
well. The logical course of action would be to do the opposite: to hold on to winning stocks in
order to further gains, while selling losing stocks in order to prevent additional losses.

The example of investors who sell winning stocks prematurely can be explained by Kahneman
and Tversky‘s study, in which individuals settled for a lower guaranteed gain of $500 as
compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in the
study and investors who hold winning stocks in the real world are overeager to cash in on the
gains that have already been guaranteed. They are unwilling to take a risk to earn larger gains.
This is an example of typical risk-averse behavior. (To read more, check out A Look At Exit
Strategies and The Importance Of A Profit/Loss Plan.)

On the other hand, though, investors also tend to hold on to losing stocks for too long. Investors
tend to be willing to assume a higher level of risk on the chance that they could avoid the
negative utility of a potential loss (just like the participants in the study). In reality, though, many
losing stocks never recover, and those investors end up incurring greater and greater losses as a
result. (To learn more, read The Art Of Selling A Losing Position.)

Avoiding the Disposition Effect

It is possible to reduce the disposition effect, thanks to a concept called hedonic framing. As an
example, for situations in which you have a chance of thinking of something as one large gain or
as a number of smaller gains (i.e. finding a $100 bill versus finding a $50 bill and then later
finding another $50 bill), it‘s best to think of the latter option. This will help to maximize the
positive utility you experience.

On the other hand, for situations where you could either think of a situation as one large loss or
as a number of smaller losses (i.e. losing $100 or losing $50 two times), it‘s better to think of the
situation as one large loss. This creates less negative utility, because there is a difference in the
amount of pain associated with combining the losses and with the amount associated with taking
multiple smaller losses.

In a situation you could interpret as either one large gain with a smaller loss or a single smaller
gain (i.e. $100 and -$50, or +$50), it‘s likely that you‘ll achieve more positive utility from the
single smaller gain.
Lastly, in situations that could be thought of as a large loss with a smaller gain or as a smaller
loss (i.e., -$100 and +55, versus -$45), it may be best to frame the situation as separate losses and
gains.

Try these methods of framing your thoughts, and you may find that they help you to experience
these situations more positively. Training yourself to reframe situations in this way can also help
to avoid the disposition effect.

More from pdf of prospect theory. https://www.press.umich.edu/pdf/0472108670-02.pdf

MODULE 3
The Behavioral Foundations –Role of behavioural antecedents Role of Emotions, Mood,
Sentiments.

http://www.publishingindia.com/GetBrochure.aspx?query=UERGQnJvY2h1cmVzfC8yNDMxL
nBkZnwvMjQzMS5wZGY=
https://investedwithyou.com/behavioral-finance/

https://journal-archieves31.webs.com/793-801.pdf

https://www.ukessays.com/dissertation/examples/finance/effect-of-demographics-on-the-choice-
of-investments.php

Role of psychological disposition.

The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency
of investors to sell assets that have increased in value, while keeping assets that have dropped in
value. Hersh Shefrin and Meir Statman identified and named the effect in their 1985 paper,
which found that people dislike losing significantly more than they enjoy winning. The
disposition effect has been described as "[o]ne of the most robust facts about the trading of
individual investors" because investors will hold stocks that have lost value yet sell stocks that
have gained value."[1] In 1979, Daniel Kahneman and Amos Tversky traced the cause of the
disposition effect to the so-called "prospect theory". The prospect theory proposes that when an
individual is presented with two equal choices, one having possible gains and the other with
possible losses, the individual is more likely to opt for the former choice even though both would
yield the same economic result. The disposition effect can be minimized by a mental approach
called "hedonic framing". https://breakingdownfinance.com/finance-topics/behavioral-
finance/disposition-effect/

Limits to Arbitrage

https://www.palermo.edu/economicas/PDF_2012/PBR7/PBR_01MiguelHerschberg.pdf

Limits to arbitrage is a theory that, due to restrictions that are placed on funds that would
ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices may remain
in a non-equilibrium state for protracted periods of time.

The efficient-market hypothesis assumes that whenever mispricing of a publicly traded stock
occurs, an opportunity for low-risk profit is created for rational traders. The low-risk profit
opportunity exists through the tool of arbitrage, which, briefly, is buying and selling differently
priced items of the same value, and pocketing the difference. If a stock falls away from its
equilibrium price (let us say it becomes undervalued) due to irrational trading (noise traders),
rational investors will (in this case) take a long position while going short a proxy security, or
another stock with similar characteristics.

Rational traders usually work for professional money management firms, and invest other
peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing
persists for an extended period, clients of the money management firm can (and do) formulate
the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order
to deliver funds, the manager must unwind the position at a loss. The threat of this action on
behalf of clients causes professional managers to be less vigilant to take advantage of these
opportunities. This has the tendency to exacerbate the problem of pricing inefficiency.

In 1998, the American firm Long-Term Capital Management (LTCM) fell victim to limits-to-
arbitrage. The company had staked its investments on the convergence of the prices of certain
bonds. These bond prices were guaranteed to converge in the long run. However, in the short
run, due to the East Asian financial crisis and the Russian government's debt default, panicked
investors traded against LTCM's position, and so the prices that had been expected to converge
were, instead, driven further apart. This caused LTCM to face margin calls. Because the firm did
not have enough money to cover these calls, they were compelled to close out their positions and
to take great losses; whereas, if they had held their positions, they then could have made
significant profits.

Module IV
Cognitive Biases, its affect on stock market prices: https://seekingalpha.com/article/4158260-5-
cognitive-biases-heuristics-impact-trading-decisions?page=2

Social Phenomena is stock market prices

http://base.socioeco.org/docs/1.2.1_resume_boguslavskaya.demushkina.pdf

Dividend effect.

https://alphaarchitect.com/2017/06/02/the-dividend-disconnect-behavioral-finance-strikes-again/

What is {term}? Dividend Signaling

Dividend signaling is a theory that suggests that when a company announcement of an increase
in dividend payouts is an indication of positive future prospects. The theory is directly tied to
game theory; managers with good investment potential are more likely to signal. While the
concept of dividend signaling has been widely contested, the theory is still a concept used by
proponents of inefficient markets.

BREAKING DOWN Dividend Signaling

Because the dividend signaling theory has been treated skeptically by analysts and investors,
there has been regular testing of the theory. On the whole, studies indicate that dividend
signaling does occur. Increases in a company's dividend payout generally forecast positive future
performance of the company's stock while, conversely, decreases in dividend payouts tend to
accurately portend negative future performance by the company.
Testing the Theory

Two professors at the Massachusetts Institute of Technology (MIT), James Poterba and
Lawrence Summers, wrote a series of papers from 1983 to 1985 that documented testing of the
signaling theory. After obtaining empirical data on the relative market value of dividends and
capital gains, the effect of dividend taxation on dividend payout and the impact of dividend
taxation on investment, Poterba and Lawrence developed a "traditional view" of dividends that
includes the theories that dividends signal some private information about profitability.
According to the theory, stock prices tend to rise when a company announces an increase in
dividend payouts and fall when dividends are to be decreased. The researchers concluded that
there is no discernible difference between the hypothesis that an increased dividend conveys
good news and the hypothesis that the dividend increase is good news for investors.

Profitability

The dividend signaling theory suggests that companies paying the highest level of dividends are,
or should be, more profitable than otherwise identical companies paying smaller dividends. This
concept indicates that the signaling theory can be disputed if an investor examines how
extensively current dividends act as predictors of future earnings. Earlier studies, conducted from
1973 to 1978, concluded that a firm‘s dividends are basically unrelated to the earnings that
follow. However, a study in 1987 concluded that analysts typically correct earnings forecasts as a
response to unexpected changes in dividend payouts, and these corrections are a rational
response.

Dividend Signaling in the Real World

A company with a lengthy history of dividend increases each year is signaling to the market that
its management and board anticipate future profits. Dividends are typically not increased unless
the board is certain the cost can be sustained. There are several stocks with histories that seem
promising for investors seeking ever-increasing dividends, for example, National Fuel Gas, the
FedEx Corporation and the Franco-Nevada Corporation.

Fatal Attractions

https://www.capitalideasonline.com/wordpress/fatal-attractions/

Module V
Investing Styles and Behavioral Finance

You can apply your knowledge of findings from the field of behavioral finance in a number of
ways. First, you can be alert to and counteract your natural tendencies toward investor bias and
framing. For example, you can avoid availability bias by gathering news from different sources
and by keeping the news in historical perspective.

A long-term viewpoint can also help you avoid anchoring or assuming that current performance
indicates future performance. At the same time, keep in mind that current market trends are not
the same as the past trends they may resemble. For example, factors leading to stock market
crashes include elements unique to each.

Ambiguity aversion can be useful if your uncertainty is caused by a lack of information, as it can
let you know when you need to do more homework. On the other hand, aversion to ambiguity
can blind you to promising opportunities.

Loss aversion, like any fear, is useful when it keeps you from taking too much risk, but not when
it keeps you from profitable opportunities. Using knowledge to best assess the scope and
probability of loss is a way to see the loss in context. Likewise, segregating investments by their
goals, risks, liquidity, and time horizons may be useful for, say, encouraging you to save for
retirement or some other goal.

Your best protection against your own behavioral impulses, however, is to have a plan based on
an objective analysis of goals, risk tolerance, and constraints, taking your entire portfolio into
account. Review your plan at least once a year as circumstances and asset values may have
changed. Having a plan in place helps you counteract investor biases.

Following your investment policy or plan, you determine the capital and asset allocations that
can produce your desired return objective and risk tolerance within your defined constraints.
Your asset allocation should provide diversification, a good idea whatever your investment
strategy is.

Market Timing and Technical Analysis

Asset bubbles and market crashes are largely a matter of timing. If you could anticipate a bubble
and invest just before it began and divest just before it burst, you would get maximum return.
That sort of precise timing, however, is nearly impossible to achieve. To time events precisely,
you would constantly have to watch for new information, and even then, the information from
different sources may be contradictory, or there may be information available to others that you
do not have. Taken together, your chances of profitably timing a bubble or crash are fairly slim.

Market timing was defined in Chapter 12 "Investing" as an asset allocation strategy. Because of
the difficulty of predicting asset bubbles and crashes, however, and because of the biases in
financial behavior, individual investors typically develop a ―buy-and-hold‖ strategy. You invest
in a diversified portfolio that reflects your return objectives and risk tolerance, and you hold on
to it. You review the asset allocation periodically so it remains in line with your return and risk
preferences or as your constraints shift. You rely on your plan to make progress toward your
investment goals and to resist the temptations that are the subjects of the field of behavioral
finance.
As you read in Chapter 12 "Investing", a passive investment strategy ignores security selection
by using index funds for asset classes. An active strategy, in contrast, involves selecting
securities with a view to market timing in the selection of securities and asset allocation.

An investment strategy based on the idea that timing is everything is called technical analysis.
Technical analysis involves analyzing securities in terms of their history, expressed, for example,
in the form of charts of market data such as price and volume. Technical analysts are sometimes
referred to as chartists. Chartists do not consider the intrinsic value of a security—a concern of
fundamental analysis. Instead, using charts of past price changes and returns, technical analysts
try to predict a security‘s future market movement.

Candlestick charting, with its dozens of symbols, is used as a way to ―see‖ market timing trends.
It is believed to have been invented by an eighteenth-century Japanese rice trader named Homma
Munehisa.Gregory L. Morris, Candlestick Charting Explained: Timeless Techniques for Trading
Stocks and Futures (New York: McGraw-Hill, 2006). Although charting and technical analysis
has its proponents, fundamental analysis of value remains essential to investment strategy, along
with analyzing information about the economy, industry, and specific asset.

Figure 13.10 A Candlestick Chart Used in Technical AnalysisCourtesy of StockCharts.com,

http://stockcharts.com.

Technical analysts use charts like this one, showing the NASDAQ‘s performance for April and
May 2009. Each symbol annotating the graph, such as the shaded and clear ―candlesticks,‖
represents financial data. Chartists interpret the patterns they see on these charts as indicators of
future price moves and returns as driven by traders‘ financial behavior.

Financial Fraud

Fraud is certainly not an investment strategy, but bubbles attract fraudulent schemers as well as
investors and speculators. A loss of market efficiency and signs of greater investor irrationality
attract con men to the markets. It is easier to convince a ―mark‖ of the credibility and viability of
a fraudulent scheme when there is general prosperity, rising asset values, and lower perceived
risks.

During the post–World War I expansion and stock bubble of the 1920s, for example, Charles
Ponzi created the first Ponzi scheme, a variation of the classic pyramid scheme. The pyramid
scheme creates ―returns‖ from new members‘ deposits rather than from real earnings in the
market. The originator gets a number of people to invest, each of whom recruits more, and so on.
The money from each group of investors, however, rather than being invested, is used to pay
―returns‖ to the previous group of investors. The scheme is uncovered when there are not enough
―returns‖ to go around. Thus, the originator and early investors may get rich, while later
investors lose all their money.

During the prosperity of the 1980s, 1990s, and 2000s, the American financier Bernard Madoff
notoriously ran a variation of the Ponzi scheme. His fraud, costing investors around the world
billions of dollars, lasted through several stock bubbles and a real estate bubble before being
exposed in 2008.

Fraud can be perpetrated at the corporate level as well. Enron Corporation was an innovator in
developing markets for energy commodities such as oil, natural gas, and electricity. Its image
was of a model corporation that encouraged bright thinkers to go ―outside the box.‖
Unfortunately, that ethos of innovation took a wrong turn when several of its corporate officers
conspired to hide the company‘s investment risks from financing complicated subsidiaries that
existed ―off balance sheet.‖ In the fall of 2001, with investor confidence shaken by the dotcom
bust and the post-9/11 deepening of the recession, the fraud began to unravel. By the time the
company declared bankruptcy, its stock value was less than one dollar per share, and its major
corporate officers were under indictment (and later convicted) for fraud.

How can you avoid a fraud? Unfortunately, there are no foolproof rules. You can be alert to the
investment advisor who pushes a particular investment (see Chapter 14 "The Practice of
Investment"). You can do your own research and gather as much independent information on the
investment as possible. The best advice, however, may come in the adage, ―If it seems too good
to be true, it probably is.‖ The capital markets are full of buyers and sellers of capital who are
serious traders. The chances are extremely slim that any one of them has discovered a market
inefficiency undiscoverable by others and exploitable only by him or her. There is too much at
stake.

Shadow of the Past

1. Introduction

Risk taking may well be one of the most fundamental dimensions that economists
investigate in order to explain indi- vidual differences in behavior. Empirical studies by
economists have identified a wide range of individual characteristics, such as age,
gender, education, wealth, parental education, cognitive ability and financial literacy, that
appear to be corre- lated with risk taking (see, e.g., Guiso & Paiella, 2008; Dohmen et al.,
2011). However, despite these important discoveries, risk taking still remains, to a large
extent, a ‗black box‘ as relatively little is known about its determinants, i.e., how it gets
formed (see, e.g., Dohmen, Falk, Huffman, & Sunde, 2012). Recent studies show that
genetic traits account for about 20% of the variation across individuals in financial risk
aversion (Cesarini, Johannesson, Lichtenstein, Sandewall, & Wallace, 2010). Other work
indicates that risk attitudes can vary in the short-term for the same person as a function
of, e.g., identity priming(Benjamin, Choi, & Strickland, 2010). There is also a small but
growing body of research by economists, which we review in the next section, examining
the impact of life experiences on risk attitudes. Part of this research has investigated the
role of prior experiences, such as financial busts, that could plausibly change people‘s
expectations of likely outcomes; that is, for example, living through the Great Depression
could make people believe that depressions are more likely to occur or are likely to be
more severe.
In this paper, we aim to contribute to this strand of literature by providing an empirical
analysis focusing on the relation- ship between individual-specific life-course negative
events and financial risk taking. Drawing on research in psychology showing that
traumatic events can produce wide-ranging and long-lasting consequences on one‘s
dispositions, we hypothe- size that individuals who have experienced negative past
events out of their control will significantly differ in their willing- ness to take financial
risks. In other words, one‘s personal history might cast a long shadow extending to
current decision- making also within unrelated domains.
We proxy financial risk taking with panel observations on the holdings of stocks in the
financial portfolio taken from the 2004–2010 waves of the US Health and Retirement
Study. An already established strand of literature looks at the financial decision to hold
stocks to infer risk taking (since the seminal contributions of Cohn, Lewellen, Lease, and
Schlarbaum (1975) and Friend and Blume (1975)) and connects it to macroeconomic
events in life history, such as the recent financial crisis (Malmendier & Nagel, 2011;
Bucciol & Miniaci, 2014). The contribution of this paper is fivefold: first, unlike most of
prior economics work on the theme, we mainly focus on the relationship between risk
taking and individual-specific, idiosyn- cratic – rather than collectively experienced –
events out of an individual‘s control; second, we are able to compare the impact on
portfolio choice of such personal events with the impact of a macroeconomic shock such
as the recent financial crisis; third, we jointly consider different shocks, which allows us
to compare the relative strength of different effects; fourth, we analyze the relationship
between financial risk taking and the timing of the events that we examine; fifth, we seek
to understand whether financial risk taking varies as a result of a shift in preferences or
via a change in beliefs.
We provide evidence that risk taking is significantly correlated with two types of prior
life experience, that is having been victim of a serious physical attack and the loss of a
child. Specifically, we observe less frequent investment in stocks when any of these
two events is present. These correlations survive after controlling for classic socio-
demographic determinants of risk taking as well as for the impact of the recent financial
crisis. The effects of the two personal events are quantitatively similar to that of the
collectively experienced event of passing from year 2004 to year 2008, i.e., going
through the first phase of the current crisis. Our analysis further reveals that the negative
correlation of risk taking with child loss is long-lasting, as opposed to the correlation
with a physical attack that disappears after few years. Next, we provide evidence
suggesting that financial risk taking seems to vary as a result of a shift in preferences
more than via a change in beliefs.
The remainder of the paper proceeds as follows. Section 2 provides a short and
selective review of the streams of lit- erature investigating the long-term effects of prior
life experiences. Section 3 describes our data and methodology. Section 4 illustrates
our core findings and Section 5 concludes.

2. Prior life experiences and current decision-making

In the last decades, several papers both within and outside the economics literature
explored the effects of prior life expe- riences on current individual decisions and well-
being. Outside the economics literature, a number of recent studies have shed light on the
adverse (direct and indirect) economic consequences later in life of negative life events
such as losing a child (e.g., Knodel & Im-em, 2004), having a life-threatening illness
(see, e.g., Sachs & Malaney, 2002, on malaria; Yach, Stuckler, & Brownell, 2006, on
obesity) and suffering a physical loss (e.g., Miller, Cohen, & Rossman, 1993, on injuries
from violent crime; Boden, Biddle, & Spieler, 2001, on workplace illnesses and injuries).
On top of economic consequences, a large variety of arti- cles in medicine and psychiatry
document that exposure to trauma can produce lasting consequences on mental and
physical health (Carmil & Breznitz, 1991), including the well-known ‗post-traumatic
stress disorder‘ (Yehuda, 2002). In the psy- chology literature, Sacco, Galletto, and
Blanzieri (2003) examine the psychological impact of the 9/11 terrorist attack on Italian
subjects‘ risk aversion, offering evidence of an indirect effect of that traumatic event.
Holman and Silver (1998) inves- tigate the relation between temporal orientation and
long-term psychological distress in three samples of traumatized indi- viduals. Their
findings indicate that a tendency to focus on prior life experiences is correlated with high
levels of distress long after the trauma had passed. Elder (1999) documents that
individuals are most affected by seismic events early in life.
In economics, the empirical literature examining the influence of negative past
experiences on individuals‘ preferences, beliefs and other economically relevant
variables is relatively new. Some recent papers focus on the impact on individuals‘ risk
attitude of collectively experienced events such as natural disasters (e.g., floods,
hurricanes and earthquakes), wars and economic crises. In particular, the works closest to
ours are Eckel, El-Gamal, and Wilson (2009), Malmendier and Nagel (2011), Cassar,
 Healy, and von Kessler (2011), Voors et al. (2012), Callen, Isaqzadeh, Long, and
Sprenger (2014), Cameron and Shah (2015) and Kim and Lee (2014).1 Eckel et al. (2009)
examine the short-term effects of Hurricane Katrina and find that the evacuees exhibit
risk-loving behavior. Malmendier and Nagel (2011) investigate whether the experience
of a large macroe- conomic shock such as the Great Depression shaped the willingness
to take risks of so called ‗Depression Babies‘ later in life.

Strategies for overcoming Psychological Biases:

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of
investment decision making. Here are some strategies for overcoming the psychological biases:

1. Understanding the Biases.

Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is
particularly relevant for investors, "We have met the enemy - and it's us". So, understand
your biases (the enemy within) as this is an important step in avoiding them.

2. Focus on the Big Picture.

Develop an investment policy and put it down on paper. Doing so will make you react less
impulsively to the gyrations of the market.

3. Follow a Set of Quantitative Investment Criteria.

It is helpful to use a set of quantitative criteria such as

 the price-earnings ratio being not more than 15,

 the price to book ratio not more than 5,
 the growth rate of earnings being at least 12%, and so on.

Quantitative criteria tend to mitigate the influence of emotion, hearsay, rumour and
psychological biases.

4. Diversify

If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you
are less prone to do something drastically when you incur losses in one or two stocks because
these losses are likely to be offset by gains elsewhere.
5. Control Your Investment Environment

If you are on a diet, you should not have tempting sweets and savouries on your dining table.
Likewise, if you want to discipline your investment activity, you should regulate or control
your investment environment. Here are some ways of doing so:

 Check your stocks only once every month.

 Trade only once every month and preferably on the same day of the month.
 Review your portfolio once or twice a year.

6. Strive to Earn Market Returns

Seek to earn returns in line with what the market offers. If you strive to outperform the
market, you are likely to succumb to psychological biases.

7. Review Your Biases Periodically

Once in a year, review your psychological biases. This will throw up pointers to contain such
biases in the future.

https://www.citeman.com/4431-strategies-for-overcoming-psychological-biases.html