Behavioral Finance

Maria Jorgeth Carbon-Dosdos

 Course description:
• This course describes how individuals and firms make financial decisions,
and how those decisions might deviate from those predicted by traditional
financial or economic theory. Students explore the existence of psychological
biases in financial decision-making, and examine the impacts of these biases
in financial markets and other financial settings. The course examines how
the insights of behavioral finance complements the traditional finance
paradigm.
 Course Objective
• Understanding the basic concepts and theories of behavioral finance
• Determining the investor’s psychology
• Examining market strategies
 Nature of Behavioral Finance
• Most people know that emotions affect investment decisions. People in the
industry commonly talk about the role greed and fear play in driving stock
markets. Behavioral finance extends this analysis to the role of biases in
decision making, such as the use of simple rules of thumb for making
complex investment decisions.
• Behavioral finance takes the insights of psychological research and applies
them to financial decision
 Scope
• Identify Investor’s Personality
• Helps to identify risk
• Provides explanations to various corporate activities
• Enhance the skill set to investment advisors
• To understand the market anomalies
 Objective of Behavioral Finance
• To study emerging issues in financial market
• To understand the psychology of the investors
• To study the change in trends in investment
 Objective of Behavioral Finance
• To study the investment decision
• Develop the strategy of financial decision
• Study the scope of investment decision
What is Behavioral Finance?
• Behavioral finance is the study of the influence of psychology on the
behavior of investors or financial analysts.
• It also includes the subsequent effects on the markets. It focuses on the
fact that investors are not always rational, have limits to their self-
control, and are influenced by their own biases
He
Self Deception

a process of denying or rationalizing

away the relevance, significance, or
importance of opposing evidence
and logical argument.
Self-deception involves
convincing oneself of a truth (or
lack of truth) so that one does not
reveal any self-knowledge of
the deception.
The starting point…
 Why we do it anyway?

self-deception can arise from

• selective attention,
• biased information search,
• forgetting.
 Detecting your Self Deception

• 1. Notice your emotion.

• 2. Notice your thoughts.
• 3. Notice your behavior.
https://www.psychologytoday.com/u
s/blog/naked-truth/201405/how-do-
i-know-when-i-am-lying-myself
 Heuristic Simplification

• are commonly defined as cognitive

shortcuts or rules of thumb
that simplify decisions, especially
under conditions of uncertainty.
 Brief History
• 1950s that the Nobel-prize winning
psychologist Herbert Simon suggested
that while people strive to make
rational choices, human judgment is
subject to cognitive limitations. Purely
rational decisions would involve
weighing such factors as potential
costs against possible benefits.
• During the 1970s, psychologists
Amos Tversky and Daniel
Kahneman presented their research
on the cognitive biases. They
proposed that these biases
influence how people think and the
judgments people make.
As a result of these limitations, we are forced to rely on mental
shortcuts to help us make sense of the world.

Simon's research demonstrated that humans were limited in

their ability to make rational decisions,

but it was Tversky and Kahneman's work that introduced the

specific ways of thinking people rely on to simplify the decision-
making process.2
 Common Uses

Attribute substitution:
• Theories suggest people substitute
simpler but related questions in
place of more complex and
difficult questions.
 Common Uses

Effort reduction
• : According to this theory, people
utilize heuristics as a type of
cognitive laziness. Heuristics reduce
the mental effort required to make
choices and decisions.
 Common Uses

Fast and frugal:

• Still other theories argue that
heuristics are actually more accurate
than they are biased.4
• In other words, we use heuristics
because they are fast and usually
correct.
 Types of Heuristics

The availability heuristic

• describes our tendency to think that
whatever is easiest for us to recall
should provide the best context for
future predictions.
•
 Types of Heuristics

representative
• involves estimating the likelihood
of an event by comparing it to an
existing prototype that already
exists in our minds. This prototype
is what we think is the most
relevant or typical example of a
particular event or object.
 Types of Heuristics

The Affect heuristic

• a type of mental shortcut in which
people make decisions that are
heavily influenced by their current
emotions
Just because something has worked in the past does
not mean that it will work again, and relying on an
existing heuristic can make it difficult to see
alternative solutions or come up with new ideas.
Emotions
 Emotion

Emotions are biological states associated with

the nervous system brought on by
neurophysiological changes variously
associated with thoughts, feelings, behavioural
responses, and a degree of pleasure or
displeasure.
According to the American Psychological Association
(APA), emotion is defined as “a complex reaction
pattern, involving experiential, behavioral and
physiological elements.” Emotions are how individuals
deal with matters or situations they find personally
significant.
 3 Components of Emotions
• Subjective Experiences
• Physiological Responses
• BEHAVIORAL RESPONSES
 Psychology of financial market
• Market Psychology
• Boom and cycles
• Psychology of investors
• Psychology of the rational man
 Psychology of investors’ behavior
• Behavioral approach
• Cognitive approach
• Psychoanalytic approach
• Humanistic approach
• Eclectic approach
 Behavioral Finance: Market Strategy
• Market timing
• Buy and hold strategy
• Technical analysis as tool
• Behavioral indicators
 Psychology of financial market
- Modern investment theory says that, at all times, market prices equal
fundamental value and that asset returns in the cross-section reflect relative
exposures to systematic non-diversifiable risk. Despite decades of data analysis,
empirical support for this theory remains thin.
 Prospect Theory
• States that people make decisions based on the potential value of losses and
gains rather than the final outcome, and that people evaluate these losses and
gains using certain heuristics.

• The foundation of this theory is that investors are much more distressed by
prospective losses than they are happy about prospective gains.
 Loss aversion theory
• In economics and decision theory, loss aversion refers to people’s tendency
to strongly prefer avoiding losses to acquiring gains.
• Most studies suggest that losses are twice as powerful, psychology, as gains.

• This leads to risk aversion when people evaluate an outcome comprising

similar gains and losses; since people prefer avoiding losses to making gains.
 Neoclassical Economics Assumptions
1. People have rational preferences across possible outcomes or states of
nature.
2. People maximize utility and firms maximize profits.

3. People make independent decisions based on all relevant information

 Activity 1: The power of persuasion
• Knowing that majority of the people are risk averse, how would you
convince people who have negative notion on INSURANCE?
 framing
• an example of cognitive bias, in which people react to a particular choice in
different ways depending on how it is presented; e.g. as a loss or as a gain.
People tend to avoid risk when a positive frame is presented but seek risks
when a negative frame is presented
 Activity 2: Use the framing effect
• Within your group, think of a situation.
• First round: Present the usual way of presenting the information.
• Second round: Present it again but this time, make use of the framing effect
Personal Biases
 Top 10 Biases in Behavioral Finance
1. Overconfidence and illusion control 6. Representative Bias
2. Self Attribution Bias 7. Framing Bias
3. Hindsight Bias 8. Anchoring Bias
4. Confirmation Bias 9. Loss Aversion
5. Narrative Fallacy 10. Herding Mentality

https://corporatefinanceinstitute.com/resources/knowledge/trading-
investing/behavioral-finance/
Overconfidence bias
 Self Attribution Bias
If it was good, I did it. If it was bad, it was a
fluke.
 Hindsight Bias
"I knew it all along"
 Confirmation Bias
Finding information that confirms our belief
 Narrative Fallacy
When stories compromise objective decision
making
 Representativeness Heuristic
When the similarity of objects is confused with
the probability of an outcome
 Framing Bias
How the way information is presented can
influence decisions
 Anchoring Bias
How the first data point we see impacts our
decisions
 Loss Aversion
A preference to avoid losses in investing
 Herd Mentality
A form of social bias that impacts investors
The Concept of Behavioral Types
 Attempts to explain the differences in
PEOPLE
ASTROLOGY
it was believed that the alignment of the heavens influenced behavior.
there were 12 signs in four groupings symbolized by earth, air, fire, and
water
 Attempts to explain the differences in
PEOPLE
• HIPPOCRATES with his concept of the four temperaments( choleric,
phlegmatic, sanguine, and melancholy).
He believed that personality was shaped by blood, phlegm, black bile
and yellow bile
 Attempts to explain the differences in
PEOPLE
• DR. CARL JUNG in 1923 wrote the book Psychological Types and
described the
intuitor, thinker, feeler, and sensor. His was the most sophisticated scientific work
done at the time
• Availability bias
• Ostrich bias
• Anchoring
• Placebo effect
• Choice-support bias
• confirmation
 Mental Accounting
• Mental accounting theory, framing means that the way a person subjectively
frames a transaction in their mind will determine the utility they receive or
expect.

• It is a tendency of the brain to create short cuts with how it perceived the
information and ending up with outcomes that is difficult to be viewed in
any other way. The results of these mental accounting are that it influence
decisions in unexpected ways
 Investors’ Disposition Effect
• Is an anomaly discovered in behavioral finance. It relates to the tendency of
investors to sell shares whose price has increased, while keeping assets that
have dropped in value
Availability bias Bandwagon
Ostrich effect Conservatism bias
Anchoring Blind-spot bias
Placebo effect Outcome bias
Choice-support bias Overconfidence
Confirmation Recency
Survivorship bias Selective perception
Stereotyping Framing
 Investors’ Disposition Effect
• Investors are less willing to recognize losses(which they would be forced to
do if they sold assets which had fallen in value), but are more willing to
recognize gains. This is irrational behavior, as the future performance of
equity is unrelated to its purchase price.
Cognitive biases affecting investment decisions
Rational Decisions vs. Emotions
How mood impacts the decisions of individual
investors?
ALTRUISM
Is there goodness in selfishness?

Does selfishness contribute to

something greater? Better?
Realization here, do your share.
Would you believe, that it’s started with selfishness that we are
enjoying things TODAY? How could that be possible?
Rational Managers vs. Irrational Investors
“ The investor’s chief problem, and even his worst enemy, is likely to be
himself ”.
--Benjamin Graham

“ There are three factors that influence the market: FEAR, GREED, and
GREED”. --Market folklore
 3 Economic Conditions that Warrant Market
Efficiency
• Investor rationality
• Independent deviations from rationality
• Arbitrage the simultaneous buying and selling of securities, currency, or
commodities in different markets or in derivative forms in order to take
advantage of differing prices for the same asset.
"profitable arbitrage opportunities"
 Absence of the 3 components lead market to
be inefficient
• It must be that many, many investors make irrational decisions
• The collective irrationality of these investors leads to an overly optimistic or
pessimistic market situation
• this situation cannot be corrected via arbitrage by rational, well-capitalized
investors
 Are People Rational
• Cognitive Psychologists found that our actions are influenced by heuristics and
biases.
Frame dependence
Mental accounting
The house money effect
overconfidence
• Prospect theory provides an alternative to classical, rational economic decision-
making : investors are much more distressed by prospective losses than they are
happy about prospective gains
 Do managers take advantage of mispricing?

• Company name changes

 CALENDAR ANOMALIES
• HOLIDAY EFFECT
-regularity of unusually good performance for stocks on the day
prior to market-closing holidays
 CALENDAR ANOMALIES
MONDAY EFFECT
-regularity of Monday being the only day of the week that averages
a negative rate of return
 CALENDAR ANOMALIES
BEGINNING OF DAY EFFECT
-tendency of stock prices to rise during the first 45 minutes of the
trading day
 CALENDAR ANOMALIES
END OF DAY EFFECT
-tendency of stock prices to rise near the close of the trading day
 CALENDAR ANOMALIES
POLITICAL- CYCLE EFFECT
-pattern of abnormally high annual returns during the third and last
years of a presidential administration
Having known those CALENDAR ANOMALIES, how will you act on
your investments?
 How to avoid investment pitfalls?
• Stay the course- maintain a long-term perspective, and seek to build significant
wealth with regular contributions to your investment portfolio
• Long-run returns reflect fundamental business prospects- don’t be surprised
when pigs don’t fly. In the long run, you will do as well as the business you invest in.
• Dumb money ceases to be dumb when it realizes its limitations. Low-cost
stock and bond index investing is best for almost everyone. Fewer that one in ten
professionals consistently beat the markets. Most active speculators lose money
 How to avoid investment pitfalls?
• Don’t confuse luck with brains. Most investors think they are smart if the
stocks they buy go up and think they are merely unlucky when their stocks
go down.
• Cut your losses and let your profits run. Admit when you are wrong. Be
willing to make small mistakes. Being wrong and stubborn is expensive.
How to avoid investment pitfalls?
How to avoid investment pitfalls?
Debiasing, Education & Client Management
 1. Awareness of Bias
• How we form impressions of other people. (Halo effect)
• How we acquire information. (Ostrich Bias)
• How we prepare for the future.(Pessimism Bias)
 Steps to Eliminate Bias
1. Awareness of bias
2. Motivation to eliminate bias
3. Direction and magnitude awareness of bias
4. Ability to eliminate bias
Strategies for Helping those Affected by Bias

How we prepare for the future.

 Answer in 3-5 sentences only.

1. Explain how limited self-control and procrastination affect savings?

2. Create a plan to avoid the tendencies on limited self-control and
procrastination.
3. How this mantra” pay yourself first” help you for your retirement?
4. From your test 1, nos. 1 to 9 answer, choose a bias and determine how will
you perform debiasing?