 Traditional versus behavioral perspectives

 Building blocks of behavioral finance

 Utility theory and Bayes formula
 Cognitive errors and emotional biases
 Bounded Rationality and Prospect Theory
 Implications of behavioral biases in
investment decisions and in corporate finance

2
Behavioral finance attempts to understand and
explain how reasoning errors influence
financial decisions

The integration of behavioral and traditional

finance has the potential to produce a superior
economic outcome, closer to the optimal
outcome while being easier for an investor to
adhere to in practice

3
Traditional Finance Behavioral Finance
Grounded in neoclassical economics Grounded in psychology

Based on hypotheses about how investors Focuses on how investors and markets
and markets should behave actually behave

Individuals are assumed to be risk-averse Individuals may have different attitudes

towards risk

Individuals are self-interested utility Individuals consider alternatives based on

maximizers their framing and evaluate the gains and
losses based by establishing a reference

Individuals are rational Individuals are normal, their choices are

rational but subject to limitations of
knowledge and cognitive capacity

Markets are efficient Markets are not efficient since there are
limits to arbitrage

4
 Limits to Arbitrage
Traditional finance holds the hypothesis that
“prices are right” and “there is no free lunch”.

 Psychology
We expect to see agents deviating from full
rationality. Full rationality means:
✓ Beliefs are updated based on Bayes’ law
✓ Choices made are consistent with expected utility theorem

5
Strategies designed to correct the mispricing
can be both risky and costly, thereby allowing
the mispricing to survive.
➢Fundamental Risk
➢Noise Trader (technical) Risk
➢Implementation Cost
• Commissions, bid-ask spread
• Cost of learning about mispricing
• Short selling constraints

6
 Utility is the level of relative satisfaction
received from the consumption of goods and
services
 If the individual’s preferences satisfy the
axioms of completeness, transitivity,
continuity and independence, he is said to be
rational and his preferences can be
represented by a utility function
 Decision makers choose between risky
alternatives by comparing the expected utility

7
 It is a mathematical rule explaining how
existing probability beliefs should be
changed given new information
 Rational decision maker, given new
information is expected to update beliefs
about probabilities according to Bayes’
formula
𝑃 𝐵𝐴
𝑃 𝐴𝐵 = 𝑃(𝐴)
𝑃 𝐵

8
All fund managers fall into one of two groups:
 Stars are the best managers. The probability that
a star will beat the market in any given year is
75%.
 Ordinary, non-star managers, by contrast, are
just as likely to beat the market as they are to
underperform it.
Moreover, of a given pool of managers, only 16%
turn out to be stars.
A new manager was added to your portfolio last
year and he was successful in beating the market.
What is the probability that the manager is a star?

𝑃 𝐵𝑆
𝑃 𝑆𝐵 = 𝑃(𝑆)
𝑃 𝐵
9
 Behavioral finance micro examines behaviors
or biases that distinguish individual investors
from the rational investors of traditional
finance

 Behavioral finance macro considers market

anomalies that distinguish markets from the
efficient markets of traditional finance

10
 Cognitive Errors: Biases resulting from basic
statistical, information-processing, or
memory errors

 Emotional Biases: Biases resulting from

intuition, impulse or due to the reasoning
influenced by feelings

11
 Belief Perseverance Biases: These result due
to the mental discomfort that occurs when
new information conflicts with previously held
belief.
 Conservatism Bias: Reluctance to revise one’s beliefs
 Confirmation Bias: Favoring information that confirms
previous beliefs
 Representativeness Bias: “Good companies make good
investments”
 Illusion of control: Assuming control over the outcome
 Hindsight Bias: Belief you knew about the outcome
before it occurred

12
 Processing Errors: These result when the
information is processed and used illogically or
irrationally and is less related to the errors of
memory
 Anchoring and Adjustment Bias
 Over emphasize prior (first) information e.g. “sales”
 Mental Accounting Bias
 Treat money differently depending on the source
 Framing Bias
 Decisions are affected by how information is presented
 “10% fat vs. 90% fat free”
 Availability Bias
 Rely on recent (available) information e.g. “news”
 Bears, bubbles, crashes

13
 Loss Aversion Bias
◦ Prefer avoiding losses to acquiring gains.
 Overconfidence Bias
 Illusion of knowledge
 Self attribution: Attribute failures to external factors
 Self-Control Bias
◦ Failure to act in pursuit of long-term goals
◦ Spend instead of reinvest (e.g. dividends)
 Status Quo Bias
◦ Sticking with decisions made previously
 Endowment Bias
◦ Tendency to value your owned object higher than market price
e.g. ticket
 Regret Aversion Bias
◦ Decision made to avoid regretting in the future
◦ “Negative marking”

14
 People are not fully rational while making
decisions and do not necessarily optimize but
rather satisfice when arriving at their
decisions
 The term “satisfice” describes decisions,
actions, and outcomes that may not be
optimal, but they are adequate

15
 Choices among risky prospects exhibit
several pervasive effects that are inconsistent
with traditional utility theory:
◦ People think in terms of expected utility relative to
a reference point (e.g. current wealth) rather than
absolute outcomes.
◦ In case of positive prospects, people overweigh
outcomes that are considered certain, relative to
outcomes which are merely probable
◦ In negative domain, people demonstrate risk
seeking preference for a loss that is merely
probable over a loss that is certain

16
The value function is:
• Defined on deviations
from the reference point
• Concave for gains and
convex for losses
• Steeper for losses than
for gains

17
Example:

• A mutual fund generated

average return of 10%
during the last 3 years.

vs.

• A mutual fund has had

above average returns
over the last decade, but
the returns declined to
10% over the last 3
years.

18
 Investors Behavior
◦ Under diversification and biased portfolios
◦ Herd behavior, market bubbles and crashes
◦ Excessive trading
◦ Buying and selling decision

 Corporate Finance
◦ Security issuance and investment
◦ Cash dividend payments
◦ Managerial irrationality

19
 90 percent of investors held fewer than ten
stocks in 2001 (U.S. Survey of Consumer
Finances)
 Investors have portfolios concentrated in
stocks from same industry
 Investors are reluctant to sell assets trading
at a loss relative to the price at which they
were purchased

20
 Traditional finance claims investors to
rationally make decisions, considering the fair
prices and required returns.
 History shows that investors make similar
trading errors since they imitate each others
trading actions.
 Bubble occurs when market prices soar far
higher than what fundamentals and rational
analysis justify. Crash is a significant and
sudden drop in market-wide values

21
 According to CAPM, investors should hold
risk-free assets in combination with market
portfolio of all risky assets which is a passive
portfolio
 In reality a tremendous amount of trading
takes place every day
 Grinblatt & Keloharju (2009) showed that
trading activity increases with psychological
measures of overconfidence

22
 With limited time and attention to spend on
their investment decisions, investors are
influenced by attention-grabbing news and
other stories
 Investors are more likely to be the purchasers
of high-attention stocks

23
 When a firm’s stock price is too high, rational
manager should issue more shares and when
the price is too low, the manager should
repurchase shares
 The amount by which the stock is over or
undervalued is an important consideration
while issuing shares (Graham & Harvey, 2001)
 The irrational investor sentiments, however,
should not affect the actual new investments

24
 Stockholders who pay taxes would always
prefer that the firm repurchase shares rather
than pay a dividend
 By designating an explicit dividend payment,
firms make it easier for investors to
segregate gains and increase their utility
 Firms also consider the asymmetric reaction
between an increase and decrease in dividend

25
 Much of the evidence on takeover activity is
consistent with an economy in which there
are no overall gains to takeovers, but in
which managers are overconfident about
these gains (Roll, 1986)
 Managers overestimate the probability that
the future performance of their firms will be
good, believe the stock is underpriced and
finance accordingly

26
 Gender bias
◦ Barber and Odean (2001) find that overconfidence
leads men to invest more aggressively than women.
Men trade 45% more than women.

 Role of earnings
◦ Hinz, McCarthy, and Turner (1997) find that higher
incomes lead to more aggressive investing

27
 Research tools: neuroimaging, hormone
assays, genetic tests
 Predictive studies of decision making, which
achieve causative explanatory power (versus
correlative analyses)
 Researchers have developed interventions
that accommodate or alter the underlying
neurobiology of financial decision makers
 Neurochemicals such as dopamine
(excitatory) and serotonin (anxiolytic) can
influence financial decision-making.

28
 Screening out firms
◦ Human right violations, carbon emissions, alcohol,
defense etc.
 Mixed results about the performance of
ethical/socially responsible vs. conventional
funds.
 Shareholder activism: Active engagement of
shareholders in corporate policy, including
investment decision-making

29
 Would you invest in a hotel that is going to
generate extremely high returns but 5% of its
revenue arises out of a casino?
 When a company underpays its employees, it
will benefit the firm financially.
 If a firm dumps garbage in the environment
to save processing costs.

30
 Trading based on material, non-public
information
◦ Makes the stock market trading unfair
 Firm insiders (managers, executives,
accountant etc.) generally have insider
information about the firm
 Passing the information to someone (friend)
can lead to insider trading

31
 Difficult to prove a trade was based on insider
information
◦ Overhearing someone
 Corporations also get involved in insider
trading
◦ Example: Goldman Sachs (GS) Aluminum scam
◦ GS branch involved in Aluminum production
allegedly limited the Aluminum supply to artificially
inflate its price and invest in its futures.

32
 Jamal, an equity analyst is on a call with the CFO of a
major fashion retail company. In the call, the CFO
discloses that the majority of the firm’s workforce is
set to go on strike indefinitely. The CFO informs the
analyst that the firm is expected to miss its expected
earnings expectations for the next two quarters. Jamal
goes on to update his recommendation to a “Sell.”

 Has Jamal acted on material, non-public information?

33
 Sadiq recently had a conversation with his personal
trainer about Ufone. His trainer, an avid investor, tells
him that he believes Ufone will be acquired by a bigger
telecommunications company. Sadiq aggressively
purchases the Ufone stock.

 Has Sadiq acted on material, non-public information?

34
 Aggregate behavior does not renormalize
directly from individual behavior
◦ Many behavioral studies involve undergraduate
students instead of active practitioners
◦ What is the worst thing that can happen to you?
 Lab studies are not necessarily indicative of
real-life scenarios
◦ Example: I offer you one chocolate today OR five
chocolates in a year.
◦ I didn’t check if you even like chocolates, or how
many chocolates do you already have at home.

35
 Loss aversion (prospect theory) is perfectly
rational.
◦ The concavity/convexity is because of people’s
goals (for gains) and their condition for survival (for
losses).

36
 Barberis, N., & Thaler, R. (2003). A Survey of Behavioral Finance.
Handbook of the Economics of Finance. Elsevier Science
 Berk, J. & DeMarzo, P. (2017). Corporate Finance: The Core. England:
Pearson
 Brealey, R. A, Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles
of Corporate Finance. India: McGraw Hill
 Behavioral Finance, Individual Investors and Institutional Investors.
CFA-II Program Curriculum (2018)
 Kahneman, D. (2011). Thinking, Fast and Slow. England: Penguin
Books
 Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of
Decision under Risk. Econometrica, 47(2), 263-292
 Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2012). Fundamentals
of Corporate Finance. India: McGraw Hill

37