■ Reasons for Such Anomalies?

– Answer Lies in Behavioural Finance

■ Suppose You have an option to buy two different lotteries:
■ Price of both is same i.e. Rs. 50

– First option guarantees a sure return of Rs. 100

– Second option may give a return of Rs.0 or Rs. 200
■ Assume probability of both outcomes is .5
■ Second option outcome in terms of probability = 0*.5 + 200*.5 =Rs. 100
■ Which One will you choose ?

■ Most people may choose a confirmed return of Rs. 100. But Why ?
– Answer Lies in prospect theory
 Prospect Theory
■ What Is the Prospect Theory?
– It was developed by Kahneman and Tversky in 1979
– It is a theory that shows how people decide between alternatives that involve risk and
uncertainty (e.g. % likelihood of gains or losses).
– Basis of this theory is inherent loss eversion among investors.
– Losses impact more investors as compared to gains.
– An investor presented with a choice, both equal, will choose the one presented in terms
of potential gains.
■ Value associated with losses is higher than value associated for same amount of
gains.
■ The value function is asymmetric.
 Bias in Investors
■ Question:
– Stock ABC (An Automobile Stock) is falling from past 5 days. In last one-year Automobile industry
sales have declined by 35%.
– The Todays price of this stock Rs.55. You purchased this stock for Rs.49. As an investor you have to
take a decision whether or not to keep this stock in your portfolio. What will you do? KEEP OR SELL
– If your answer assumes that this stock has a bleak future and must be sold off immediately then you
might be subjected to Representativeness Bias as you are comparing this stock with
■ similar industry conditions and
■ past trends of price movement
■ Representativeness Bias : Kahneman and Tversky (1972)
– People “evaluate the probability of an uncertain event, or sample, by the degree to which it is:
– (i) similar in essential properties to its parent population; and
– (ii) reflects the salient features of the process by which it is generated”.

– Individuals find it easier and faster to assess how closely the event corresponds to a similar
question.
 Bias in Investors
■ Question
– Your friend (who is a stock broker) gives you advice to buy Stock of Info ltd. (A technology Giant
company). You do your research to find out that the company has setup new offices in many
cities and has undertaken new projects.
– Then, profit forecasts for this company came out. Forecasts shows a decline in profit.
– As an investor you have to take a decision whether or not to keep this stock in your portfolio.
What will you do? KEEP OR SELL

– If you are more inclined to act of initially available positive information about this stock then you
might be subjected to Conservatism Bias.

■ Conservatism Bias :
– Conservatism bias is a bias in human information processing, which refers to the tendency to
revise one's belief insufficiently when presented with new evidence.
■ Overconfidence Bias:
– overconfidence is our tendency to overestimate what we know or what we’re capable
of.
– We tend to overestimate our knowledge
– Underestimate risk
– Exaggerate our ability to control events
Arbitrage

■ Arbitrage is the purchase and sale of an asset in order to profit from a difference in the
asset's price between markets.
■ Example: Stock X is traded on Exchange 1 for Rs. 50. At the same time its price on Exchange
2 is Rs.48.
– There is possibility to buy it from exchange 2 and sell it on exchange 1 to make profit.
– This process is called Arbitrage
– This process will continue till the price on both exchanges becomes equal.

■ In an efficient market, if prices get out of line, then arbitrage forces them back.
■ The arbitrageur buys the underpriced securities (pushing up their prices) and sells the
overpriced securities (pushing down their prices).
 Arbitrage
■ Pure Arbitrage: Pure arbitrage is the sell and purchase of a particular asset occurring
simultaneously to gain profit due to a price imbalance in the market.
■ In pure arbitrage, you invest no money, take no risk and walk away with sure profits.
■ Example: Stock X is traded on Exchange 1 for Rs. 50. At the same time its price on Exchange 2 is
Rs.48.
– Short the expensive security i.e. Borrow it from someone and sell at Rs. 50 at exchange 1.
■ This is called short selling
– Then, using the money earned, purchase the stock from exchange 2 and return the borrowed
stocks to original owner.
– Thus, making a profit of Rs. 2 per share in the process.
Arbitrage

■ Video: https://www.investopedia.com/terms/a/arbitrage.asp
■ Risk Arbitrage: An investment strategy to profit from the narrowing of a gap of the
trading price of a target's stock and the acquirer's valuation of that stock in an
intended takeover deal.
■ Risk arbitrage involves buying the shares of the target and selling short the shares
of the acquirer.
Limits to Arbitrage

■ It means limits on the ability of the rational investors to exploit market inefficiencies

– Transaction costs in short selling might inhibit exploiting arbitrage opportunities

– Short selling in many countries is restricted
– The price of a security in the offsetting market may rise unexpectedly and result in a loss
for an arbitrageur.
– Arbitrage opportunities may not quickly disappear due to these limits.

■ Behavior finance argues that not every arbitrage opportunity is exploited by rational investors
as are they inherently risk averse. Even in pure arbitrage opportunity there is little uncertainty
and rational investors will try to avoid same.
PORTFOLIO
CONCEPTS
■ What is a Portfolio?

– A portfolio is a collection of financial investments like stocks, bonds,

commodities, cash, and cash equivalents

■ What Is Portfolio Return?

– Portfolio return refers to the gain or loss realized by an investment
portfolio containing several types of investments.
■ EXPECTED RETURN
■ The expected return of the investment is the weighted average of all possible returns.
If the possible returns are 10, 15, 20, 25 and 30% with equal probability, the expected
return is

1 n
■ X= Xi = 1/5( 10+15+20+25+30) = 20%
n i 1

■ If the possible returns are 10, 15, 20, 25 and 30% with .1, .2, .3, .4 , 0 probability, the
expected return is

■ = 10*.1 + 15*.2 + 20*.3 + 25*.4 + .3*0 = 20%

■ PORTFOLIO RETURN
■ The expected return of a portfolio is simply a weighted average of the expected
return of securities comprising the portfolio.
■ Thus,
n

■ Rp =  Xi Ri
i 1

– Xi = Weight of security i , Ri = expected return of security i

MEANING OF RISK

■ ELEMENTS OF RISK
■ The essence of risk in an investment is the variation in return.
■ This variation in return is caused by a number of factors that are
called the elements of risk.
■ The elements of risk may be broadly classified into two groups.
■ TOTAL RISK
■ The total variability in returns of a security represents the total risk of that security.
■ Systematic risk and unsystematic risk are the two components of total risk. Thus
■ Total risk
■ = Systematic risk + Unsystematic risk
■ SYSTEMATIC RISK
■ The portion of the variability of return of a security
that is caused by external factors, is called
systematic risk.
■ Economic and political instability, economic
recession, macro policy of the government, etc.
affect the price of all shares systematically.
■ Thus, the variation of return in shares, which is
caused by these factors, is called systematic risk.
UNSYSTEMATIC RISK:
■ The return from a security sometimes varies because of certain
factors affecting only the company issuing such security.
■ Examples are raw material scarcity, Labour strike, management
efficiency etc.
■ When variability of returns occurs because of such firm-specific
factors, it is known as unsystematic risk.
 RISK
The most popular measure of risk is the variance or standard deviation of the possible returns. The
S.D. of the below return series is calculated as follows.

Ri Ri - R ( Ri – R) 2
10 -10 100
15 -5 25
20 0 0
25 5 25
30 10 100
n n

 Ri =100, R =20
i 1
 (Ri-R)2 = 250
i 1
 n

 (Ri –R)2] = [(1/5)250] = 7.12

1
■ S.D.= σ = [ n i 1

■ The σ measure is the total risk of the security which

comprises two component: systematic variation and
unsystematic variation.
■ Total Risk
■ = Systematic risk + Unsystematic risk
■ RISK AND TIME HORIZON OF INVESTMENT

– VIDEO https://www.investopedia.com/terms/r/risk.asp
– Risk that investor can afford may also depend on time horizon of investment.
– A long time investment allows to take larger risk
– For a shorter time investment risk should be less.
■ Risk Premium

■ A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of
return.

■ Investors expect to be compensated for the risk they undertake when making an investment. This
comes in the form of a risk premium.

■ Risk Premium = Expected return - Risk free premium (Rf)

■ Video: https://www.investopedia.com/terms/r/riskpremium.asp