COURSE OUTLINE

COURSE: Behavioural Finance (15 hours)

BATCH: MBA 2019-21, TERM VI
INSTRUCTOR: UDAY DAMODARAN
CONTACT: uday@iimu.ac.in WhatsApp 9934517631

Introduction

Decision making in finance typically involves inter-temporal cash flows and are
characterized by high levels of uncertainty. How do decision makers make these
decisions? Does the psychological make-up of the decision-maker affect the way
decisions are taken and the decision outcome? Are there clearly identifiable cognitive
biases that affect the process of decision-making? Do emotions have a role to play? If, in
fact, the actual decision-making process of the individual decision maker exhibits
psychological, cognitive or emotional effects that make it deviate from the rational,
prescriptive model of decision-making what implications does it have for asset price
formation and trading/ investing decisions in the market? And for Corporate Finance
decisions?

These are the questions that we will seek to answer in this course. The course examines
whether the deviations between empirical observations from the financial markets, and
the outcomes as predicted by theories of financial economics, reflect unexplainable
anomalies or whether they can be explained using advances in the young field of
behavioural finance. To try and explain these anomalies, the course introduces students to
various models of market/ asset price behavior where at least some agents behave in
manners not consistent with models of complete rational behavior. The focus will be on
examining whether biases (or ‘flaws’) in investor decision-making are consistent and
predictable and if so, how these persistent biases can be incorporated into investment
decision making. The course draws on advances in investor psychology, crowd behavior
to understand common psychological ‘errors’ and looks at how such understanding can
be used to explain anomalies/puzzles/ paradoxes in asset price behavior.

Though this course has general relevance, it would be particularly useful for students
looking at careers in investment research, fund management and corporate finance.
Learning Objectives and Rationale

At the end of this course, you should:

1. Be able to define investment goals with clarity. In domains like fund management,
wealth management and corporate investment strategy, behavioural finance helps
in defining the investment goals in sharper and richer terms than traditional
finance.

2. Be able to create equity/investment research reports that guard against biases.

While initiating/ updating security research, analysts exhibit biases like
confirmatory bias and non-Bayesian updating; awareness of these biases and
incorporating mechanisms to deal with these biases help mitigate the effect.

3. Be able to take investment decisions that are devoid of systematic biases. Biases
like representativeness, overconfidence, over-optimism, and social herding often
impact investment decision making; incorporating mechanisms that guard against
these biases help mitigate their impact.

4. Be able to trade in assets without being tied down by systematic biases. Both in
high frequency (example, stock trading) and in low frequency (example, mergers
and acquisitions) decision makers must guard against systematic biases like loss
aversion, endowment bias and the disposition effect

Session-wise Plan

Session Topic

One Introduction: Investment Decision Making Cycle: Traditional versus

Behavioral Finance

Two, Three Who is The Investor? Decoding Investor Goals via Pascal-Fermat,
Bernoulli, Fechner, Neumann-Morgenstern, Savage, Friedman, Kahneman
and Tversky

Experiments/ Instruments: St Petersburg Paradox, Risk Aversion, Allais

Paradox, Ellsberg Paradox, Reflection Effect, Framing Effect

Group Task 1: Critical evaluation and re-design of a fintech solution/

app/ financial product that aims to customize solutions incorporating
investors’ risk- return preferences

Reading: Kahneman and Tversky and the origin of behavioral

Economics, Heukelom, F, Tinbergen Institute Discussion Paper

Four, Five Researching Securities sans Biases

 Experiments/ Instruments: Confirmatory Bias, Non-Bayesian Updating

Group Task 2: Critical evaluation and re-construction of an equity/

investment research report

Reading:
1. Various Equity/ Security Research Reports
2. Aspects of Investor Psychology, Kahneman, D and Riepe,
MW (1998), Journal of Portfolio Management, Vol 24, No.4

Six, Seven Investing Biases and Blind Spots

Experiments/ Instruments: Representativeness, Overconfidence,
Herding, Extreme Probabilities, Lake Wobegon Effect, Hindsight Bias,
Attribution Bias

Group Task 3: Critical evaluation of analysts’/ corporates’ forecasting,

investment decisions

Reading: Before You Make that Big Decision, Kahneman, D, Lovallo, D

and Sibony, O, HBR June 2011

Eight, Nine The Demons That Traders Have To Confront

Experiments/ Instruments: Endowment Effect, Loss Aversion,
Disposition Effect, Status Quo Bias

Reading: The disposition effect in securities trading:an experimental

analysis , Weber, M and Camerer, CF, Journal of Economic Behavior
& Organization, 33(2), 1998

Profitability of Momentum Strategies: An Evaluation of Alternative

Explanations , Jegadeesh,N and Titman, S, The Journal of Finance,
56(2), 2001

Ten Conclusion: Investment Styles, Value Investing

Reading: Note on Behavioral Finance, Ivey Publishing

Evaluation

This course is a hands-on course that focuses on empiric data. The evaluation pattern too
reflects this emphasis; students should demonstrate an ability to use the concepts covered
in the course

2 Quizzes (end of 4th and 8th sessions) 20%

End Term 35%
3 Group Tasks 45%
Assessment Logic
The learning objectives enunciated at the beginning of this course outline seek to ensure
that your learning in this course can be used in the world of financial analysis,
investments and trading. The assessment of this learning has been designed on the
premise that this learning, in turn, requires that you remember and understand concepts
and ideas, know how to apply them and be comfortable in being able to use them to
analyze (deconstruct) situations and design (evaluate and construct) solutions. The table

below outlines a rough mapping of the evaluation components to these dimensions

Components Remembering Application of Analysis Evaluation and
and Understanding Synthesis
Understanding
Quizzes To assess To assess
retention and ability to
recollection of apply/ use
facts, concepts concepts and
from directed theories to
readings; to given data/
assess ability situations
to discuss and
explain
concepts
End Term To assess To assess ability to To assess
ability to analyze real world ability to design
apply/ use investment solutions and
concepts and situations build arguments
theories to to justify the
given data/ decision
situations
Group Tasks To assess ability to To assess
critically analyze ability to
investment ideas, design, plan
products and solutions for
decisions real life
situations; to
assess ability to
build up
arguments to
justify the
solution using
concepts and
theories

Effort

Estimated effort required to be expended on the course, outside the 15 class hours
Average reading of 1 hours per session x 10 sessions 10 hours
Preparatory Work for Quizzes and End Term 5 hours
Effort required, per person, for empiric projects 20 hours
Total 35 hours

Ethics/ Fair Play

If you indulge in any unethical practice (copying, plagiarism, etc) in any component,
small or big, it brings to question the assessment of you in every other component.
Suitable action, according to Institute rules, will be initiated.