Page 1 of 41: UNIT 1: Traditional Finance To Behavioral Finance

This course intends to provide the in-depth knowledge of behavioral finance This course intends to provide the in-depth
course intends to provide the in-depth knowledge of behavioral finance

in the scope of saving and investment. in the scope of saving and investment.
UNIT 1: Traditional Finance to Behavioral Finance empirical studies in the field of behavioural finance adopt proxies in attempt to capture or
measure the effect of such variables (Darren, 2015).
Historical perspective of behavioral finance, Rational Market Hypothesis, Modern
Considering the limitations of modern finance regarding justification of investment strategies
Portfolio theory, Capital asset pricing model, Efficient market hypothesis, agency
(Glaser & Weber, 2007) being followed by investors under different scenario, behavioural
theory.
finance models (Glaser et al., 2004) are usually developed to explain investor behaviour or
market inefficiency when rational models provide no sufficient explanation. Behavioural
1. Historical Perspective of Behavioural Finance aspects and psychology often affects the investor’s decisions (Huang Jim Yuh, 2015), which are
Behavioural Finance and study of evident from irrational decisions under the influence of attitude, overreaction, under-reaction,
investor’s psychology has focused on the rationality of their investment planning and decisions. fear, overconfidence, group behaviour etc.
It was Oscar Wilde (Wilde, 1890) who described a cynic as one who “knows value of nothing
but price of everything". Considering some equity research analysts and many researchers
having "bigger fool" theory of investing, which highlights that the value of asset is irrelevant as 2. Efficient Market Hypothesis
long as there are “bigger fools” to buy the asset. While this may provide basis to make some The Efficient Markets Hypothesis (EMH) is an investment
profit as there are some other theory which disingenuous enough to argue that the value is in theory primarily derived from concepts attributed to Eugene Fama’s research as detailed in his
the eyes of beholder (Damodaran, Applied Corporate Finance, 2003) and any price can be 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama put forth
justified as long as there are other investors willing to pay that price. There are many assets for the basic idea that it is virtually impossible to consistently “beat the market” – to make
which perception may be all that matter like painting or a sculpture, but a rational investor investment returns that outperform the overall market average as reflected by major stock
does not buy most of the assets for aesthetic or emotional purpose but financial assets are indexes.
acquired for the expected cashflows from the investment.
As there are always a large number of both buyers and sellers in the market, price movements
Modern finance assumes that markets are efficient and that agents know the probability always occur efficiently (i.e., in a timely, up-to-date manner). Thus, stocks are always trading at
distribution of future market risk (Markowitz, 1952); (Merton, 1969); (Fama, 1970). their current fair market value. The major conclusion of the theory is that since stocks always
Behavioural finance models (Glaser et al., 2004) are usually developed to explain investor trade at their fair market value, then it is virtually impossible to either buy undervalued stocks
behaviour or market inefficiency when rational models provide no sufficient explanation. at a bargain or sell overvalued stocks for extra profits. Neither expert stock analysis nor
Behavioural aspects and psychology often affects the investor’s decisions (Huang Jim Yuh, carefully implemented market timing strategies can hope to average doing any better than the
2015), which are evident from irrational decisions under the influence of overreaction, under- performance of the overall market. If that’s true, then the only way investors can generate
reaction, overconfidence, group behaviour etc. superior returns is by taking on much greater risk.
There are three variations of the hypothesis – the weak, semi-strong, and strong forms –
In recent years, many researchers in the area of finance and investment have been very active which represent three different assumed levels of market efficiency.
in behavioural finance, and many of their research works have been accepted in the top
Weak Form
journals in the field of financial economics (Henker, Henker, & Mitsios, 2006). This shows that
The weak form of the EMH assumes that the prices of securities reflect all available public
behavioural finance (Huang Jim Yuh, 2015) is becoming an increasingly significant area for
market information but may not reflect new information that is not yet publicly available. It
research.
additionally assumes that past information regarding price, volume, and returns is independent
of future prices.
Behavioural Finance is one of the dynamic and fully developed fields which have its own The weak form EMH implies that technical trading strategies cannot provide consistent
principle and methodology (Redhead, 2008). Behavioural finance came in existence due to
excess returns because past price performance can’t predict future price action that will be
limitations of traditional theories and finance to support the investment and saving decisions
based on new information. The weak form, while it discounts technical analysis, leaves open the
(De Bondt & Thaler, 1985; Werner DeBondt, 2010). While traditional finance formulates the
possibility that superior fundamental analysis may provide a means of outperforming the
investment strategy whereas behavioural finance focuses on the decision process of its overall market average return on investment.
execution (MacKenzie, Fabian, & Lucia, 2006). Many of the key variables in behavioural models
are neither observable nor measurable directly to researchers analysing data, thus most of the
Sunil Kushwaha Page 1 Sunil Kushwaha Page 2
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This course intends to provide the in-depth knowledge of behavioral finance This course intends to provide the in-depth knowledge of behavioral finance
Semi-strong Form
The semi-strong form of the theory dismisses the usefulness of both technical and
3. Modern Portfolio Theory
fundamental analysis. The semi-strong form of the EMH incorporates the weak form
assumptions and expands on this by assuming that prices adjust quickly to any new public
The modern portfolio theory (MPT) is a practical method for selecting investments in order to
information that becomes available, therefore rendering fundamental analysis incapable of
maximize their overall returns within an acceptable level of risk.
having any predictive power about future price movements. For example, when the quarterly
policy rates are declared by RBI, we can see prices rapidly adjusting as the market take in the American economist Harry Markowitz pioneered this theory in his paper "Portfolio Selection,"
new information. which was published in the Journal of Finance in 1952. He was later awarded a Nobel Prize for
Strong Form his work on modern portfolio theory.
The strong form of the EMH holds that prices always reflect the entirety of both public and
Assumptions
private information. This includes all publicly available information, both historical and new, or
current, as well as insider information. Even information not publicly available to investors,
(a) The market is efficient and all investors have in their knowledge all the facts about the stock
such as private information known only to a company’s CEO, is assumed to be always already
market and so an investor can continuously make superior returns.
factored into the company’s current stock price.
So, according to the strong form of the EMH, not even insider knowledge can give (b) All investors before making any investments have a common goal. This is the avoidance of
investors a predictive edge that will enable them to consistently generate returns that risk because they are risk averse.
outperform the overall market average.
(c) All investors would like to earn the maximum rate of return that they can achieve from their
Unfavorable Empirical Evidence for EMH (Limitations)
investments.
1. The first and foremost disadvantage of the efficient market hypothesis is that while this
theory argues that markets are efficient but history is filled with examples where stock (d) The investors base their decisions on the expected rate of return of an investment.
markets become irrational due to panic and stocks were available at throwaway prices
and people made a lot of money by buying stocks at throwaway prices. (e) Markowitz brought out the theory that it was a useful insight to find out how the security
2. The argument that fundamental analysis and technical analysis are a waste of time is returns are correlated to each other. By combining the assets in such a way that they give the
also not correct because just chances of accidents happening due to the bad driver are lowest risk, maximum returns could be brought out by the investor.
more as compared to a good driver in the same way while there can bad fundamental
analyst or technical analyst but saying that fundamental and technical analysis is of no use (f) From the above, it is clear that every investor assumes that while making an investment, he
is not the right thing to say as there are many people who have to earn consistent above will combine his investments in such a way that he gets a maximum return and is surrounded
normal return following fundamental analysis and technical analysis. by minimum risk.
3. The argument that stock markets is nothing but speculation is flawed as in the case of
gambling one places bets on the basis of his or her gut feeling but when it comes to stock (g) The investor assumes that greater or larger the return that he achieves on his investments,
markets one takes risks but it is not only on the basis of gut feeling but other factors like the higher the risk factor that surrounds him. On the contrary, when risks are low, the return
the financial position of the company, market trend, technical trends, economic and stocks can also be expected to be low.
specific news and so on.
4. Small-firm effect: Small firms have abnormally high returns (h) The investor can reduce his risk if he adds investments to his portfolio.
5. Market overreaction to news announcements
6. Excessive stock price volatility relative to fluctuations in fundamental value
7. Mean reversion (low returns today → higher returns in future, and vice versa) 6. New
information is not always immediately incorporated into stock prices
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Illustration
Calculate Expected return if 2/3 of the investment is in Stock A. and justify that in both
properity and depression for Stock A, MPT gives better return.
4. Capital Asset Pricing Model
The risk and return model that has been in use the longest and is still the standard in most real
world analyses is the capital asset pricing model (CAPM).
The Efficient Frontier

Assumptions
• At every level of return, investors can create a portfolio that offers the lowest possible risk.
1. The capital asset pricing model assumes that there are no transactions costs,
• For every level of risk, investors can create a portfolio that offers the highest return.
Any portfolio that falls outside the Efficient Frontier is considered sub-optimal for one of
2. All assets are traded and that investments are infinitely divisible (i.e., you can buy any
two reasons: it carries too much risk relative to its return, or too little return relative to its risk.
fraction of a unit of the asset).
A portfolio that lies below the Efficient Frontier doesn’t provide enough return when compared
to the level of risk. Portfolios found to the right of the Efficient Frontier have a higher level of
3. It also assumes that there is no private information and that investors therefore cannot
risk for the defined rate of return.
find under or overvalued assets in the market place.
At every point on the Efficient Frontier, investors can construct at least one portfolio from
all available investments that features the expected risk and return corresponding to that point.
By making these assumptions, it eliminates the factors that cause investors to stop diversifying.
A portfolio found on the upper portion of the curve is efficient, as it gives the maximum
With these assumptions in place, the logical end limit of diversification is to hold every traded
expected return for the given level of risk. MPT shows that the overall expected return of a
risky asset (stocks, bonds and real assets included) in your portfolio, in proportion to their
portfolio is the weighted average of the expected returns of the individual assets themselves.
market value11. This portfolio of every traded risky asset in the market place is called the
For example, assume that an investor has a two-asset portfolio worth Rs 1 million. Asset X has
market portfolio.
an expected return of 7%, and Asset Y has an expected return of 12%. The portfolio has
Rs.800,000 in Asset X and Rs 200,000 in Asset Y. Based on these figures, the expected return of
the portfolio is: Expected Return on asset i
Portfolio expected return = ((Rs 800,000 / Rs 1 million) x 7%) + ((Rs 200,000 / Rs 1 million) x
12%) = 5.6% + 2.4% = 8%
Rf = Risk-free Rate
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E(Rm) = Expected Return on market portfolio Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an
βi = Beta of asset i
example, consider an electric utility company with a β of 0.45, which would have returned only
 The riskless asset is defined to be an asset where the investor knows the expected return 45% of what the market returned in a given period.
with certainty for the time horizon of the analysis. Consequently, the riskless rate used will
vary depending upon whether the time period for the expected return is one year, five years Negative β – A company with a negative β is negatively correlated to the returns of the market.
or ten years.
For example, a gold company with a β of -0.2, which would have returned -2% when the market
 The risk premium is the premium demanded by investors for investing in the market was up 10%.
portfolio, which includes all risky assets in the market, instead of investing in a riskless
asset. Thus, it does not relate to any individual risky asset but to risky assets as a class. Illustration
 The beta, which we defined to be the covariance of the asset divided by the market portfolio, Calculate the expected return on a stock, using the Capital Asset Pricing Model (CAPM) formula.
is the only firm-specific input in this equation. In other words, the only reason two Suppose the following information about a stock is known:
investments have different expected returns in the capital asset pricing model is because
 It trades on the BSE and its operations are based in the India
they have different betas.  Current yield on a India 10-year treasury is 5.5%
 The average excess historical annual return for Indian stocks is 9.5%
 The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the
Sensex-30 over the last 2 years)
5. Agency theory.
Agency theory is a concept used to explain the important relationships between principals and
their relative agent. In the most basic sense, the principal is someone who heavily relies on an
agent to execute specific financial decisions and transactions that can result in fluctuating
outcomes.
Because the principal relies so heavily on the agent to make the right decision, there may be an
assortment of conflicts or disagreements. Agency theory dives into such relationships.
In terms of business, the principal is considered to be a shareholder, while the agent is

considered to be a company executive. Although it may not seem like it, shareholders and
company executives are tightly connected. Each of their actions greatly affects the position of
High β – A company with a β that’s greater than 1 is more volatile than the market. For one another.
example, a high-risk technology company with a β of 1.75 would have returned 175% of what
the market returned in a given period (typically measured weekly).
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Causes of Agency Problems 2. Restrictions
 Imposing restrictions or abolishing negative restrictions is a good way to significantly

As mentioned throughout the text, the agency theory explores the distinctive relationship
reduce the effect of agency loss.
between a principal and their agent. Throughout the relationship, there is a number of actions
and decisions that are made by the agent on behalf of the principal.  Setting specific restrictions on factors such as agency power allows the principal to feel
more confident in their relative agent.
The same actions and decisions are what generate disagreements and conflict between the two
 Conversely, abolishing negative restrictions is beneficial because it instills trust within
parties. To explain in more depth, listed below are the main causes of agency problems:
the agent and allows them to make decisions freely on behalf of the principal.
 When a conflict of interest arises between the principal and the agent 3. Bonuses
 When the agent is making decisions on behalf of the principal that is not in the best
 Introducing and eradicating incentives and bonuses lessens the chances of a relationship
interest of each associated party
that consists of conflicts and disagreements.
 The agent may act independently from the principal in order to obtain some sort of
 Introducing bonuses is a good way to motivate an agent and will allow them to make
previously agreed upon incentive or bonus
decisions with the best intentions of the principal in order to achieve their desired
 Confidentiality breach regarding the personal and financial information of the principal
incentive.
 Insider trading with the information provided by the principal
 When the principal acts against the recommendations provided by the agent.  Contrarily, bonuses may motivate the agent to make decisions just for financial gain,
disregarding the best intentions of the principal to only achieve the incentive.
Considering there is power/trust allocation, it is not surprising that there is an entire theory
that explores the relationship and interactions between a principal and an agent.  Each relationship between a principal and agent is different, it is crucial to choose the
best-fitted methods for each specific situation to ensure a positive, healthy relationship.
Reducing Agency Problems
1. Transparency
 To reduce the potential influx of agency problems, it is crucial for both the principal and
the agent to be completely transparent with one another.
 Decisions and transactions that will be implemented must be agreed upon by each party
and must be reasonably fair.
 Once transparency is present, conflict is reduced due to the fact that there is less
confusion on decision-making and fewer implications that one party is against the other.
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UNIT 2: Behavioral Biases
Syllabus: Categorization of biases, Heuristics, Anchoring, Self-deception, Frame

dependent biases, Role of regret, responsibility and expert advice
1. Categorization of Biases
The rationality of investors became debatable from the time standard finance theories could
not give sufficient explanation for the stock market anomalies.. The mental processes that are a
part of cognitive psychology have been examined by various experts with respect to decision
making under uncertainty. One of the significant contributions to this body of literature is by
Raiffa (1968). The author analyzes decisions under three approaches that provide a more
pragmatic view of an individual’s thought process. These approaches are mentioned as follows.
 Normative Approach: It is concerned with rational decision making process. It provides
ideal solution which a decision making process should strive to achieve.
 Descriptive Approach: It deals with the manner in which people actually make
decisions in the real life situations.
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 Prescriptive Approach: It provides the individuals with practical advice and tools that
might help them in achieving results that are in close approximation to the normative
analysis.
Behavioral finance captures the role of behavioral biases in investor decision making. Shefrin
(2000) broadly classifies these biases into two types: heuristic driven biases and frame 2. Overconfidence
dependent biases
It is defined as the investors’ tendency to overestimate the precision of their knowledge about
the value of a security. Gervais and Odean (2001) formulate a multi-period market model to
 Heuristic driven biases: Shefrin (2000) recognizes that financial practitioners use rules
estimate overconfidence. They propose that overconfidence is enhanced in those investors who
of thumb or heuristics to process data and make decisions. For instance, people believe
have experienced high returns; as a result they trade more frequently. Therefore
that future performance of the stock can be best predicted by past performance. The
overconfidence leads to increase in trading volume. On the other hand, a loss in the market
author categorizes such biases under heuristic theme which includes overconfidence,
reduces overconfidence level and subsequently the transaction volume.
anchoring and adjustment, reinforcement learning, excessive optimism and pessimism.
 Frame dependent biases: The decision process of financial practitioners is also

influenced by the way they frame their options. This theme includes biases like narrow
framing, mental accounting and the disposition effect.
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Most of these researches reveal that overconfidence is an illusion of superior knowledge in

investors, which is strengthened by their past successes. This tendency makes them trade more The empirical evidence of representativeness has been given by Dhar and Kumar (2001) who
as they become sure of the positive outcome. However increase in trading volume comes with examines the stock price trend for stocks bought by more than 62,000 households at a discount
high a trading cost which proves to be detrimental to the portfolio performance. brokerage during a 5-year period. The author finds that investors tend to buy stocks with
recent positive abnormal returns. This is consistent with the heuristic that the past price trend
is representative of the future price trend.
3. Optimism
Another instance is presented by Kaestner (2005) who uses the data on current and past
In financial context optimism (pessimism) is defined as the propensity of investors to
earnings for U.S. listed companies for the period of 1983-1999 and suggest that investor
overestimate (underestimate) the expected mean returns of the risky asset. Researchers have
overreaction to earnings announcement could be attributed to representativeness bias. The
studied this bias with respect to its impact on the stock markets as well as the factors that drive
author states that investors initially extrapolate the recent earnings surprise and hence
this bias. Toshino and Suto (2004) investigate optimism bias in Japanese institutional investors.
overreact to subsequent earnings surprise.
They use survey based data and find that the optimistic investors are more sensitive towards
positive market news. They selectively incorporate only good news in their decision making
process. Further, investors affected by optimism bias tend to undervalue the risk of familiar 5. Availability bias:
investment products such that they are more optimistic towards the domestic market than
In this case people evaluate the probability of an outcome based on the familiarity or
foreign markets.
prevalence of that particular outcome. People prone to availability bias give higher likelihood to
Shefrin and Statman (2011) find that excessive optimism can create speculative bubbles in
the events which they can easily recall as compared to the ones that difficult to remember or
financial markets by inflating the prices of securities above their intrinsic values. They further
comprehend. Kliger and Kudryavtsev (2010) identify this bias in investors’ reaction to analysts’
state that if bubbles last long enough, some pessimists might become convinced that they are
recommendation revisions. They use daily market returns as a proxy for information on
wrong and can convert into optimists and in the process they are likely to intensify this
outcome availability. They find that stock price reaction to recommendation revisions (up or
phenomenon.
down) is stronger when accompanied by index returns in the same direction.
Optimism (pessimism) is a very influential bias. It is responsible for setting the mood of the
financial markets. This bias is driven by past returns that have an impact on return expectations
return tolerance and risk perception of investors. This bias is so potent that it can create stock
6. Anchoring and Adjustment bias:
market bubbles and can convert even pessimists to optimists.
This bias comes into play when people have to estimate an unknown value or magnitude. Here
people start their estimation by guessing some initial value or an “anchor”. This anchor is then
adjusted and refined to arrive at the final estimate. Campbell and Sharpe (2009) investigate the
4. Representativeness
presence of anchoring bias in analysts’ forecasts of monthly economic releases for a period of
It is the tendency of individuals to estimate the likelihood of an event by comparing it to a 1991 to 2006.
previous incident that already exists in their minds. This existing incident is generally what they
consider to be the most relevant or typical example of the current event.
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They find that forecasts of any given release were anchored towards the recent months’ Shefrin (2000) describes narrow framing as the tendency of investors to treat repeated risks as
realized values of that release, thereby giving rise to predictable surprises. This effect is if they were a one-shot deal. Barberis and Huang (2006) elaborate this bias in the context of
consistent for each of the key releases. The aforementioned researches substantiate the gambling. They state that, it is the phenomenon wherein people evaluate each new gamble in
importance of the representativeness, availability and anchoring bias. It can be observed that isolation, separating it from their other risks. In other words, people will ignore all the previous
representativeness is based on stereotypes and it causes positive earnings surprises to be choices that determine their overall wealth risk and directly derive the utility from their
followed by more positive surprises and negative surprises by more negative surprises. current risk. Liu and Wang (2010) document the presence of narrow framing effect in the
options trading market. They used the daily trading volume data of Taiwan Futures Exchange
for a period of 2001 to 2004. The findings of this study indicate that investors could easily
7. Loss aversion: become susceptible to narrow framing when trading in the complex derivatives market. They
simplify complicated trading strategies into understandable trading decisions. The study also
It is introduced by Kahneman and Tversky (1979) and refers to the tendency of individuals to
supports the fact that traders’ professionalism, sophistication and experience can reduce this
strongly avoid losses as compared obtaining gains. This is because loss brings regret and impact
bias to a certain extent.
is much greater than that of gains.
Several researchers have studied the impact of loss aversion in financial markets. Joshua D.
9. Mental accounting:
Coval and Tyler Shumway (2005) analyze the effect of loss aversion bias in terms of risk taking
in market makers. They show that in intra-day trading, a loss in the morning leads to higher risk Its concept is given by Thaler (1999). It is defined as the tendency of individuals to separate
taking behavior in the afternoon. Berkelaar and Kouwenberg (2008) examine the impact of their information into manageable mental accounts. Thaler (1999) explains that mental
heterogeneous loss averse investors on asset prices using annual U.S. consumption data for a accounting is a set of cognitive operations used by individuals to organize, evaluate, and keep
period of 1889 to 1985. Their study shows that in a good state loss averse investor gradually track of financial activities. Mental accounting comprises of three components. First component
become less risk averse as wealth rises above their reference point, pushing equity prices up. captures how outcomes are perceived and experienced, how decisions are made and
On the other hand, when wealth drops below the reference point the investors become risk subsequently evaluated. Second component involves the assignment of activities to specific
seeking and demand for stock increases drastically. accounts. The final component focuses on the frequency with which accounts are evaluated and
‘choice bracketing’.
These studies reveal that there is a differential impact of gains and losses on decision outcome.
Further, the pain of loss is described to be greater than pleasure of an equal amount of gain, Barberis and Huang (2001) study investors’ mental accounting using simulated data of
which makes the investors more sensitive to a change in the loss. These researches also throw equilibrium firm-level stock returns. They find that the investors’ system of mental accounting
light on the risk attitude pattern of individuals. It is seen that people become risk seeker or less affects asset prices. They track the changes in portfolio performance as the individual’s decision
risk averse in the prospect experiencing loss of high probability. frame shifts from stock accounting to portfolio accounting. Their results reveal that when this
happens, the mean value of individual stock return falls, the stocks become less volatile and
more correlated with each other.
8. Narrow framing:
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Both narrow framing and mental accounting are cognitive processes that simplify the complex The above mentioned empirical evidences on the disposition effect show that this bias has an
decision making problem for investors. In narrow framing, individuals treat their risks in impact on trading volume of stocks. Further, this bias gets intensified in the presence of
isolation rather than taking a holistic view. This bias can lead to overestimation of risk and uncertainty and has the strength to drive momentum in the stock market.
make the investors myopic in their investment outlook. On the other hand, during mental
accounting people segregate the information into different mental accounts. They evaluate the
performance of each account separately instead of evaluating the performance of their portfolio 11. Re g r e t
as a whole. So although, this bias helps the investors in managing complex information, it can Investor confidence, emotions and psychology play a powerful role in driving
create distortion in asset prices. share markets. Past experiences, pre-conceived ideas and fear of regret are just a few of the
biases and behaviours that can lead investors to make emotional and often irrational decisions.
Regret theory, studied in behavioral finance, is a concept stating that investors will feel regret if
10. The disposition effect:
a wrong decision is made and thus will consider this anticipated regret when making
Shefrin and Statman (1985) introduce the concept of the disposition effect. It is defined as the investment decisions.
tendency of investors to hold on to losing stocks and sell winning stocks early. This concept is
built on the implications of prospect theory (Kanheman & Tversky, 1979). The possible reasons Regret theory can adversely impact an investor’s rational behavior, such as dissuading them
for this effect as proposed by the authors are loss aversion, seeking pride, mental accounting from acting or motivating them to act. As a result, regret theory can impair an investor’s ability
and regret avoidance. Odean (1998b) documents the presence of the disposition effect using to make decisions that would be beneficial.
market data on 10000 discount brokerage accounts of individual investors. In his study, the
Regret Theory Example: Being More Risk Seeking
ratio of realized gain over total gains, (i.e. proportion of gains realized or PGR) and the ratio of
Akash is a conservative investor who prefers to put his money into low beta stocks. Recently, he
realized loss over total loss (i.e. proportion of loss realized PLR) are taken as measures to
notices the meme stock craze that is unfolding in the financial markets, with numerous meme
calculate the disposition effect. He finds that a majority of investors are reluctant to realize their
stocks surging by over 100%.
losses.
Akash further sees his colleagues purchasing meme stocks, and he decides to purchase some
Grinblatt and Keloharju (2001) find evidence of the disposition effect in the Finnish stock meme stocks himself, ignoring potential risks, to avoid the regret of not purchasing it if it runs up
market using a data set of shareholdings and trades of individual and institutional investors further.
between 1994 and 1997. Shumway and Wu (2006) using a sample of 13,460 Chinese investors An example of regret is an investor’s difficulty in selling a losing stock. The feeling of regret is
note that a majority of these investors exhibit the disposition effect and it drives momentum in strongest when the loss is crystallised – until that point the investor holds out hope of the stock
the Shanghai stock exchange. Kumar (2009) uses multiple measures of valuation uncertainty returning to its ‘former glory’ and avoids generating feelings of regret by holding onto
and behavioral bias proxies to find that individual investors exhibit stronger disposition effect it. Another aspect to this is that if the investor made the original investment decision by
when stocks are harder to value and when market-level uncertainty is higher. themselves, the feeling of regret is much greater than if they were following someone’s advice.
It’s not so much about the pain of making a loss, but rather the pain of being responsible for
making the decision. This could explain why investors sometimes find it easier to outsource
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This course intends to provide the in-depth knowledge of behavioral finance
in the scope of saving and investment.
their investment decisions (ie to a financial adviser) – apart from needing professional advice, it
also means some of the burden of making decisions is shared.
12 . Expert Advice
Emotion and the human psyche are indeed powerful forces, often leading investors to make
irrational decisions, or sometimes even worse, not making any decisions – both of which can be
detrimental to the long-term performance of an investor’s investment portfolio. By removing
Unit-3
these emotions and psychological behaviours from the decision making process, investors are
in a better position to make logical and rational decisions. Seeking professional investment
advice from a financial adviser, taking a long-term view, constructing portfolios based on an
investor’s risk/return profile and investing with professional fund managers are steps an Behavioral Aspects in Investing CO3
investor can take to help them achieve this.
Just like a fitness coach, a financial expert or a financial advisor or an investment helps
investors. They determine investor’s investment goals, create a balanced plan to meet those Investor Behavior, Psychographic Models,
goals, keep a check on investment portfolio. They also ensure regular monitoring of progress to
Market outcomes, Value Investing, Guidelines
ensure that it is aligned with end goals.
for overcoming Psychological biases.
Sunil Kushwaha Page 11
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Investors Behaviour Investors Behaviour
• Investors behavior is impacted by various Perception of Value
heuristics and other influences • Do not have an adequate understanding of or
PORTRAIT OF AN INDIVIDUAL INVESTOR ability to use the valuation techniques
• Perception of Price Movements: recommended in finance texts.
• Spot trends and see patterns where none exist. • Perceive value on the basis of popular models or
Naively extrapolate recent behaviour on the mental frames that are socially shared through
future. stories in the news media.
• Be overconfident of their prediction because they • Cannot distinguish good stocks from good
anchor too much on their most likely forecast. companies
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Investors Behaviour Investors Behaviour
Managing Risk and Return Trading Practices
• Many households are under-diversified, ignoring the • Seasoned traders use a variety of rules and pre-
important lesson of modern portfolio that ‘diversification commitment techniques, such as stop-loss order, to
pays.’ control emotion and discipline themselves.
• The idea that risk is defined at the portfolio level—and not at
the level of individual assets—and that risk depends on co-
variation between returns is alien to many investors. • Most individuals, however, lack such discipline.
• Many people believe that after committing their funds they
can manage risk through knowledge and trading skills. • They trade shares on impulse or on random tips from
• Most households over-invest in riskless assets, foregoing the acquaintances, without prior planning.
attractive long-term returns offered by stocks. When
confronted with price volatility, they act myopically. Prospect
• Their trading sentiment trails the market: they tend to
theory explains this puzzle.
buy when the market rises and sell when the market falls
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Psychographic Model
Barnewell Two-Way Model
Passive investors are characterized as individuals who have
become wealthy passively - by inheriting, by a professional career,
or by risking the money of others rather than their own money. To
these investors security is more important than risk In addition,
certain classes of occupation are more likely to contain passive
investors. For example, non-surgical doctors, corporate executives,
lawyers and accountants who work in companies.
Passive investors make good clients because they tend to trust

their financial advisor and are more likely to delegate the running
of their financial affairs. And because they are risk averse, they
tend to like diversified portfolios of investments in quality
companies or investment products.
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Psychographic Model Bailard, Biehl and Kaiser Five-Way model
Active investors, according to Barnwell, are those who have
achieved significant wealth, or earned well, during their own
lifetime. They are more likely to take risks in investing because
they have previous experience of taking risks in their previous
wealth creation. These individuals have a high-risk tolerance
and less of a need for security. They also need to feel in control
of their investments, often to the extent of becoming highly
involved with the running of their investments, researching or
becoming overly involved with technicalities.
Active investors are more likely to get personally involved with

the running of their financial affairs, and may believe they
know more than their advisor does. They are less likely to
delegate the maintenance of those parts of their investment
portfolio in which they believe they have experience or have
had personal success.
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Bailard, Biehl and Kaiser Five-Way model Bailard, Biehl and Kaiser Five-Way model
• Adventurers may hold highly undiversified • Individualists are independent and confident, which may be
reflected in their choice of employment (Successful business
portfolios because they are confident and willing owner which tends to be individualistic in approach). They like
to make their own decisions but only after careful analysis. They
to take chances. Their confidence leads them to are pleasant to advise because they will listen and process
make their own decisions and makes them information rationally.
reluctant to take advice. This presents a challenge • Guardians are cautious and concerned about the future. As
for an investment adviser. people age and approach retirement, they may become
guardians. They are concerned about protecting their assets and
may seek advice from those they perceive as being more
knowledgeable than themselves.
• Celebrities like to be the center of attention. They
may hold opinions about some things but to a • Straight arrows Straight arrows are sensible and secure. They
fall near the center of the graph. They are willing to take on
certain extent recognize their limitations and may some risk in the expectation of earning a commensurate return.
be willing to seek and take advice about investing.
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Value Investing Value Investing
“Price is what you pay, Value is what you get.” • The goal of value investing is to identify undervalued
Benjamin Graham stocks.
• The price of a stock is dependent on the expectations of the
people in the market. In bullish times people are willing to pay • This is in contrast to strategies which have as their goal the
a higher price to own a piece of the company and in bearish identification of stocks with other attractive aspects.
times they are willing to pay much less. That is the reason
value investors buy stocks during bearish times as the
expectations of investors are running low. • A top-down value investing analysis begins with a look at
the economy followed by a thorough exploration of the
• When one buys a stock, one is buying a business. It is industry and the company.
necessary to understand that the business is good and
sustainable. Its earnings stream is also predictable. The price • Most of your effort should be spent at the company level,
the investor pays for this business is important. A value since this is where you will have the best chance of
investor will buy this business at a much lower value than the
fundamentals justify.
enhancing returns.
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VALUE ANALYSIS VALUE ANALYSIS
Step-2:The next step can be an industry analysis
• Screening process to identify particular industry
• Detailed look at the industry of interest
• An analysis of the industry can be an important feature
Step-1:The starting point for a detailed value of value investing
analysis can be the economy: (Top-down approach) Step-3:The final step can be an company analysis
• market position of the company
• The current state of the world economy?
• the financial strength, profitability and the growth
• What is the current strength of the economy? prospects
• What is the outlook for employment and inflation? • SWOT Analysis
• Where is the economy in terms of the business • Synthesize both the good and bad information about
cycle? the company and make a determination of whether or
not the company is truly undervalued.
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ESTIMATING A VALUE RANGE Guidelines to Overcome Psychological Biases
• The value range allows you to separate the buy and sell
• Understand the biases: Enemy within
signals from the background of noisy company • Focus on Big Picture: Reduce the frequency to check how well
information. investments are doing.
• The primary source of fundamental value is the stream • Rely on words and Numbers and not on Sights and Sounds
• Follow a set of Quantitative Investment Criteria: Set P/E, EPS,
of current and future dividends paid by the company. ROE, ROI etc
• As a way to estimate the company’s ability to pay • Diversify portfolio: Diversify Industry
dividends, you will focus on dividends, earnings, cash • Take Care of Downside: Risk Taking Capability
• Control your investment Environment: Controlling controllable
flow, and at times revenues, book value and assets. • Strive to earn Market Returns: Focus on Market returns rather
• It will be necessary to estimate value multipliers for than to beat market
• Track your feelings
each financial series used.
• Review your Biases
• The final value range will be an amalgamation of the
various value estimates obtained for the stock.
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UNIT 4
The material taught in traditional corporate finance courses provides powerful techniques that
Behavioral Corporate Finance CO4 in theory help managers in making decisions to maximise the value of their firms. In practice,
however, psychological pitfalls hinder managers in applying these techniques correctly.
Capital Budgeting and Investment Decisions, Dividend Policy Decisions, Financing
Behavioural corporate finance replaces the traditional rationality assumptions with
Decisions, Initial Public Offering and Mergers and Acquisitions.
behavioural assumptions that are based on empirical evidence.
Every decision made in a business has financial implications, and any decision that involves the
use of money is a corporate financial decision. Defined broadly, everything that a business does
fits under the rubric of corporate finance. It is, in fact, unfortunate that we even call the subject
corporate finance; because it suggests to many observers a
focus on how large corporations make financial decisions
and seems to exclude small and private businesses from its
purview. A more appropriate title for this book would be
Business Finance, because the basic principles remain the
same, whether one looks at large, publicly traded firms or
small, privately run businesses. All businesses have to
invest their resources wisely, find the right kind and mix of
financing to fund these investments, and return cash to the owners if there are not enough
good investments.
Firms raise funds by issuing equity, selling bonds, borrowing from banks and financial
institutions, issuing commercial paper, and
generating operating cash flows. Firms deploy funds
by investing in fixed assets (land, buildings, plant
and machineries), engaging in mergers and
Capital Budgeting and Investment Decisions
acquisitions, building inventories, giving loans and
advances, paying interest, taxes, and dividends, and The textbook approach to capital budgeting involves three major steps. First, estimate the post-
repurchasing shares. tax incremental cash flows associated with the project. Second, compute the weighted average
cost of capital (WACC). In calculating the WACC, calculate the cost of equity using the capital
Virtually all of the above-mentioned decisions asset pricing model and use market value weights. Third, determine the net present value
involve risk. The traditional approach to such decisions focuses on value maximisation using (NPV) of the project and accept it only if its NPV is positive. The NPV of a project represents its
the discounted cash flow (DCF) analysis. In DCF analysis, the expected cash flows associated contribution to the value of the firm. A close cousin of NPV is the internal rate of return (IRR)
with a decision are discounted at a risk adjusted discount rate to calculate the net present criterion. It is the discount rate at which the NPV is zero.
value. Decisions that have a positive net present value are taken as they enhance firm value.
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tendency to get entrapped into losing projects and, in their attempts to rescue them, throw
Survey Evidence on Project Adoption Criteria good money after bad.
What criteria do financial managers use to guide their capital budgeting decisions? Several
surveys have been done to answer this question. The survey evidence suggests that even The Investment Principle: Invest in assets and projects that yield a return greater than the
though in theory NPV is superior to IRR, in practice IRR has an edge over NPV. Further, the minimum acceptable hurdle rate. The hurdle rate
payback criterion, historically the most important criterion, continues to be relevant. What should be higher for riskier projects and should
explains the sustained appeal of the payback criterion and why is IRR more popular than NPV? reflect the financing mix used—owners’ funds
A comparison of NPV, IRR, and the payback criteria suggests that the payback criterion is the (equity) or borrowed money (debt). Returns on
most intuitive whereas NPV is the least intuitive. projects should be measured based on cash flows
generated and the timing of these cash flows;
Biases they should also consider both positive and
Capital budgeting decisions in practice are affected by various biases that stem from heuristics negative side effects of these projects.
and framing as discussed below:
Affect Heuristic: In addition to financial analysis, managers also rely on intuition, instinct, and Firms have scarce resources that must be allocated among competing needs. The first and
gut feeling. They want the decision to feel right emotionally. foremost function of corporate financial theory is to provide a framework for firms to make
Overconfidence: Often when managers supplant rigorous financial analysis with subjective this decision wisely. Accordingly, we define investment decisions to include not only those that
judgment, they underestimate project risk. create revenues and profits (such as introducing a new product line or expanding into a new
Excessive Optimism: Managers tend to be very optimistic about the forecasts of project cash market) but also those that save money (such as building a new and more efficient distribution
flows. A dramatic example of excessively optimistic revenue forecasts is provided by the system). Furthermore, we argue that decisions about how much and what inventory to
Channel Tunnel (the Anglo–French tunnel). The actual traffic in the opening year of the maintain and whether and how much credit to grant to customers that are traditionally
Channel Tunnel was a mere one-fifth of what the planners had forecast. categorized as working capital decisions, are ultimately investment decisions as well.
Confirmation Bias: A number of publicised failures of wrong investments began to display
serious symptoms during initial stages itself. However, the typical response was to downplay At the other end of the spectrum, broad strategic decisions regarding which markets to enter
information pointing toward problems. This is a manifestation of confirmation bias. and the acquisitions of other companies can also be considered investment decisions.
Corporate finance attempts to measure the return on a proposed investment decision and
Reluctance to Terminate Losing Projects
compare it to a minimum acceptable hurdle rate to decide whether the project is acceptable.
A basic rule of capital budgeting says that investment decisions should be guided by the net The hurdle rate has to be set higher for riskier projects and has to reflect the financing mix
present value criterion. Applied to a project ‘continuation versus abandonment’ decision, this used, i.e., the owner’s funds (equity) or borrowed money (debt).
rule says the project must be abandoned, if the net present value associated with abandonment
Dividend Policy Decisions
is greater than the net present value associated with continuation. By the same logic, the
project should be continued, if the net present value associated with continuation is greater
than the net present value associated with abandonment.
Do managers follow the logic of net present value calculations in evaluating continuation
versus abandonment decisions? It appears that they often overlook the logic. They have a
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Most businesses would undoubtedly like to have unlimited investment opportunities that yield 3. Dividends tend to follow earnings, but dividends follow a smoother path than earnings.
returns exceeding their hurdle rates, but all businesses grow and mature. As a consequence, Transitory changes in earnings are not likely to have an impact on dividend payment.
every business that thrives reaches a stage in its life when the cash flows generated by existing 4. Dividends are sticky in nature because managers are reluctant to effect dividend changes
investments is greater than the funds needed to take that may have to be reversed. They are particularly concerned about having to pull back an
on good investments. At that point, this business has increase in dividend.
to figure out ways to return the excess cash to
owners. In private businesses, this may just involve Financing Decisions
the owner withdrawing a portion of his or her funds
from the business. In a publicly traded corporation, Every business, no matter how large and complex, is ultimately funded with a mix of borrowed
this will involve either paying dividends or buying money (debt) and owner’s funds (equity). With a publicly trade firm, debt may take the form of
back stock. Note that firms that choose not to return bonds and equity is usually common stock. In a
cash to owners will accumulate cash balances that grow over time. Thus, analyzing whether private business, debt is more likely to be bank loans
and how much cash should be returned to the owners of a firm is the equivalent of asking (and and an owner’s savings represent equity. Though we
answering) the question of how much cash accumulated in a firm is too much cash. consider the existing mix of debt and equity and its
Why Companies Pay Dividends Despite the tax disadvantage of dividends and the issuance costs implications for the minimum acceptable hurdle rate
associated with external equity, firms pay dividends and investors generally regard such as part of the investment principle, we throw open
payments positively. Why? There are several plausible reasons: investors’ behavioural the question of whether the existing mix is the right
preference for dividends, information signalling, clientele effect, and agency costs. one in the financing principle section.
There might be regulatory and other real-world constraints on the financing mix that a
Investor Preference for Dividends If taxes and transaction costs are ignored, dividends and business can use, but there is ample room for flexibility within these constraints. We begin this,
capital receipts should be perfect substitutes. Yet, there appears to be a strong demand or by looking at the range of choices that exist for both private businesses and publicly traded
preference for dividends. Why? Hersh Shefrin and Meir Statman offer explanations based on firms between debt and equity. We then turn to the question of whether the existing mix of
the behavioural principles of self-control and aversion for regret. In essence, their argument is financing used by a business is optimal, given the objective function of maximizing firm value.
that investors have a preference for dividends due to behavioural reasons. Hence, dividends Although the trade-off between the benefits and costs of borrowing are established in
and capital receipts are not perfectly substitutable. qualitative terms first, we also look at quantitative approaches to arriving at the optimal mix. In
the first approach, we examine the specific conditions under which the optimal financing mix is
How Managers Think About Dividends
How do managers think about dividends? The classic answer to this question was provided the one that minimizes the minimum acceptable hurdle rate. In the second approach, we look
below: at the effects on firm value of changing the financing mix.
1. Firms set long-run payout ratios. Mature firms with fairly stable earnings have higher payout
When the optimal financing mix is different from the existing one, we map out the best ways of
ratios whereas rapidly growing firms have lower payout ratios.
getting from where we are (the current mix) to where we would like to be (the optimal),
2. Managers are concerned more about the change in the dividend than the absolute level of
keeping in mind the investment opportunities that the firm has and the need for timely
dividend. Thus, paying a dividend of Rs. 10 per share is very important if the previous year’s
responses, either because the firm is a takeover target or under threat of bankruptcy. Having
dividend per share was Rs. 5, but not a big deal if the previous year’s dividend was Rs.10 per
outlined the optimal financing mix, we turn our attention to the type of financing a business
share.
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should use, such as whether it should be long-term or short-term, whether the payments on the Initial Public Offering
financing should be fixed or variable, and if variable, what it should be a function of.
When a firm goes public its ownership becomes widely dispersed, as firms raise new equity
Using a basic proposition that a firm will minimize its risk from financing and maximize its
capital and as the original owners seek to diversify their stock holdings. A firm going public
capacity to use borrowed funds if it can match up the cash flows on the debt to the cash flows
might also be willing to under-price its shares
on the assets being financed, we design the perfect financing instrument for a firm. We then
in order to generate excess demand for the
add additional considerations relating to taxes and external monitors (equity research analysts
offering. With excess demand, the firm could
and ratings agencies) and arrive at strong conclusions about the design of the financing.
spread the shares among many different
According to the pecking order theory, there is a pecking order of financing which goes as investors, with no single investor holding a
follows: significant block of stock. This widely
 Internal finance (retained earnings) dispersed ownership structure may benefit
 Debt finance the firm by providing the company with a more liquid market for their shares. Firms might also
 External equity finance be encouraged to under price their shares by the underwriter if the investment bank holds
longterm warrants to buy more shares from the firm (over-subscription provision) if excess
A firm first taps retained earnings. Its primary attraction is that it comes out of profits and not demand is present.
much effort is required to get if. Further, the capital market ordinarily does not view the use of
Another explanation is to assume that firms under-price their IPOs to achieve higher stock
retained earnings negatively.
valuations when they expect to conduct future seasoned secondary offerings. For example, a
firm with excellent prospects for growth might be willing to leave “money on the table” in the
Behavioural Considerations
initial offering. If investors recognize and respond to this signal, then the long-term value of the
In practice, the capital structure decisions of companies are based on traditional firm‟s shares will be higher, and it can recoup the initial under-pricing costs in future equity
considerations as well as behavioural considerations. The principal behavioural factor relates offerings.
to market timing, meaning that managers take advantage of perceived market inefficiencies.
From the behavioral finance perspective, the following explanations for this irrational behavior
They issue equity when it is perceived to be overvalued; they repurchase equity when it is
are plausible. First, given the problem of the winner‟s curse, firms (in conjunction with their
perceived to be undervalued. It must be emphasised that perceptions are the key and they may
underwriters) may have to under-price shares, on average, to keep the market for IPOs
be sometimes unbiased and sometimes biased.
functioning by providing liquidity to investors and owners. This market is vital to
entrepreneurs who wish to harvest the value in their startup firms. Generally, relatively
A series of interviews conducted with chief financial officers, corporate treasurers, consultants,
unsophisticated investors receive larger allocations of the IPOs with negative returns and
and financiers revealed that practitioners find the theoretical capital structure models rather
smaller allocations of those with positive returns. Unless these investors receive winners at an
static. The interviewers pointed toward the volatility of their firms’ future cash flows and
acceptable frequency, they would eventually cease participating in the market.
uncertainties relating to investment opportunities and conditions in capital market. In view of
this, firms want to have flexibility to take advantage of unexpected investment and acquisition Another theory is that the information advantage of investment banks over IPO issuers can be
opportunities and market mispricing. utilized to under-price the issue. Arguably the underwriter knows the market and what it will
bear. An oversubscribed offering increases their attractiveness to the issuing firm. As a result,
underwriters have an incentive to under-price the IPO to ensure that investors will fully
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subscribe to the offering and maybe even want more. On the down side, if an offering is not Merger refers to a situation when two or more existing firms combine together and form a new
oversubscribed, the reputation of the underwriting syndicate may be damaged entity. Either a new company may be incorporated for this purpose or one existing company
(generally a bigger one) survives and another existing company (which is smaller) is merged
One behavioral explanation of issuer or underwriter liability is that investment bankers are
into it. Laws in India use the term amalgamation for merger.
concerned with potential lawsuits if an IPO breaks below the issue price. Underwriters would
depress the offering price to limit liability. Many underwriters frequently take warrants as part • Merger through absorption
of their compensation; under pricing makes gives these warrants immediate value. Usually
• Merger through consolidation
underwriters are obligated to prevent a price drop in the aftermarket. This is known as the
price-support explanation of under pricing. Therefore, it is apparent that under pricing is not Behavioural Considerations
an enigma but rather an explainable behavior phenomenon.

If markets are efficient and acquirers pay a premium which is less than the real synergistic
The virtual impossibility of pricing IPOs precisely in tandem with the lack of capability to gains, acquisitions should create value for the shareholders of both the acquiring company and
hedge causes underwriters to assume unquantifiable risks. It is very difficult to determine the the target company, regardless of the form (cash or stock) of compensation. Further, the level
appropriate price for an IPO. There is no recordable market price before issuing the stock. Most of acquisition activity should not be a function of the level of the stock market. Empirical
of the time, issuing companies do not have much operating history. The issuing firm will not evidence, however, suggests the following:
get full advantage of the raised capital if an IPO is priced too low. However, there is a significant
risk to the investment banks is an IPO is priced too high. An additional risk to the investment  Acquirers usually pay too much. This benefits the shareholders of the target company,
bank is that investors who bought the overpriced IPOs will shun future offers. but hurts the shareholders of the acquiring company.
 CEOs fall in love with deals and don’t walk away when they should.
Mergers and Acquisitions
 Mergers and acquisitions thrive during periods of stock market buoyancy.
 Acquirers who pay stock compensation are more likely to do value-reducing deals than
Restructuring of business is an integral part of the new economic paradigm. As controls and acquirers who pay with cash or debt.
restrictions give way to competition and free trade, restructuring and reorganization become
essential. Restructuring usually involves major organizational change such as shift in corporate What explains this empirical evidence which is at variance with what the theory predicts?
strategies to meet increased competition or changed market conditions. This activity can take Several behavioural factors seem to explain the discrepancy. The important ones are:
place internally in the form of new investments in plant and machinery, research and Winner’s Curse In a competitive bidding situation, the participating companies are
development at product and process levels. It can also take place externally through mergers notoriously vulnerable to rising commitments. The desire to win overwhelms rationality. As
and acquisitions (M&A) by which a firm may acquire another firm or by which joint venture Warren Buffett said, the thrill of the chase may blind the acquirer to the outcome thereof.
with other firms. Hence, the winner tends to overpay. In a way, the winner is an unfortunate winner. This is
This restructuring process has been mergers, acquisitions, takeovers, collaborations, referred to as the “winner’s curse” hypothesis.
consolidation, diversification etc. Domestic firms have taken steps to consolidate their position
to face increasing competitive pressures and MNC’s have taken this opportunity to enter Indian Hubris Out of misplaced confidence, the acquirer’s management tends to overestimate the
corporate sector. synergies that it hopes to realise. As Daniel Kahneman et al. put it: “Mergers tend to come in
waves during periods of economic expansion. At such times, executives can over-attribute their
company’s strong performance to their own actions and abilities rather than to the buoyant
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economy. This can, in turn, lead them to an inflated belief in their own talents.” They further UNIT 5
added: “Consequently, many M&A decisions may be the result of hubris, as the executives
evaluating an acquisition come to believe that with proper planning and superior management Psychological Planning and Future Direction CO5
skills, they could make it more valuable. Research on post-merger performance suggests that
Financial Planning Process, Components of Planning, Challenges to Behavioral Finance,
on average, they are mistaken.” Upcoming areas of research, Ethical and Social Responsibilities in Investment.
Financial Planning Process
What are financial goals?

Financial goals are the personal, big-picture objectives you set for how you’ll save and spend
money. They can be things you hope to achieve in the short term or further down the road.
Either way, it’s often easier to reach your goals if you identify them in advance.
Examples of financial goals include:
• Paying off debt.
• Saving for retirement.
• Building an emergency fund.
• Buying a home.
• Saving for a vacation.
• Starting a business.
• Feeling financially secure.
Why financial goals matter

Having financial goals can help shape your future by influencing the actions you take today. For
example, say your goal is to pay off a colossal credit card bill. You might cut back on takeout
dinners and use the money you save to make extra payments instead. Without establishing that
goal, you’re more likely to continue spending as usual while your debt piles up.
How To Set Financial Goals: 6 Simple Steps

I. Figure out what matters to you. Put everything, from the practical and pressing to the
whimsical and distant, on the table for inspection and weighing.
II. Sort out what’s within reach, what will take a bit of time, and which must be part of a long-
term strategy.
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III. Apply a SMART- goal strategy. That is, make certain your ambitions are Specific, plans for the turnaround of his company, relying heavily on its global reach and intellectual
Measurable, Achievable, Relevant, and Timely. SMART. properties. He overlooked the company’s junk bond rating, inefficient bureaucracy, and weak
IV. Create a realistic budget. Get a strong handle on what’s coming in and what’s going out, then internal controls.
work it to address your goals. Use your budget to plug leaks in your financial ship.
V. With any luck, your tough, realistic, water-tight budget will show at least a handful of Components of Planning
leftover dollars. Whatever that amount is, have it automatically directed into a separate
account designed to address the first couple of things on your list of priorities. A financial plan is a report of your current income, long-term and short-term goals, and the
VI. Monitor your progress. ways or potential investments to achieve those goals. The efficiency of any financial plan can be
determined by the investment amount and time to hit your targets. To plan and implement a
Like all expenses, financial goals should be included in your budget. That way, you can take valuable financial strategy, it is crucial to analyze its components.
concrete steps toward reaching them while leaving room for other costs. Plan out how much
time it will take to reach each goal and how much money you’ll need to contribute within that
period
What is Financial Planning?

Financial Planning is the process of estimating the capital required and determining it’s
competition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise. Financial planning is a step-by-step
approach to meet one’s life goals.
Importance of Financial Planning
• Adequate funds have to be ensured.
• Financial Planning helps in ensuring a reasonable balance between outflow and inflow
1. Cash-Flow Management:
of funds so that stability is maintained.
To truly understand your current assets, liabilities, and net worth; it is important to identify –
• Financial Planning ensures that the suppliers of funds are easily investing in companies
in writing – the status of your personal and professional income and expense balance sheet.
which exercise financial planning.
We include goal planning as part of this step because setting realistic goals and achieving them
• Financial Planning helps in making growth and expansion programmes which helps in
is highly dependent on your ability to save for those goals.
long-run survival of the company.
Other aspects of cash flow management include the debt elimination plan, if needed, as well as
• Financial Planning reduces uncertainties with regards to changing market trends which
a comprehensive savings plan.
can be faced easily through enough funds.
• Financial Planning helps in reducing the uncertainties which can be a hindrance to 2. Investment Management
growth of the company. This helps in ensuring stability an d profitability in concern. When most people think of financial planning, they may think of investing. Many people ask,
“What is the latest hot stock?” or “What is the best mutual fund?” Studies have shown that
Most people have difficulty in planning properly. They are prone to planning fallacy. For those are bad questions because investing is not about the latest stock or timing the market.
example, Michael Zafi rovsky, CEO of Nortel Networks, was unrealistically optimistic in his
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Investing is a strategy that takes your goals, your risk tolerance, and your timeline into Retirement planning helps you set a goal for when you want to retire and your income and
consideration. Then, developing the best investing strategy to meet those goals. Your investing lifestyle objectives during retirement. Your advisor can determine if your current savings are
strategy should be the foundation for meeting your retirement goals, education goals, and on track and provide guidance on strategies to help achieve those goals. Retirement Planning
other long-term goals. also helps you answer questions, such as –
If done properly, your portfolio strategy should include an asset allocation mix that minimizes
risk through a global and well-diversified (properly correlated) set of assets such as stocks, How to manage my retirement corpus?
bonds, and other alternatives. Is my retirement corpus enough?
The asset mix and correlation factors of the portfolio are personalized to your specific needs Can I retire early?
and are key to the long-term success of the portfolio. How to get regular income?
Should I invest in risky assets after retirement?
3.Tax Planning How to increase my pension?
In order to maximize and preserve your investment returns, an eye toward tax management is
crucial. There is a number of tax-reduction strategies and methods for generating tax-free
income and wealth transfer considerations; which can be achieved by way of tax planning.
No matter what your age is, one should consider, understand and implement this in a proactive
What are Benefits of financial planning?
manner. • Increase your savings It may be possible to save money without having a financial
For example, Debt Funds can benefit you more when held for more than 3 years than bank plan. But it may not be the most efficient way to go about it. When you create a financial
fixed deposits from a tax perspective. plan, you get a good deal of insight into your income and expenses. You can track and
cut down your costs consciously. This automatically increases your savings in the long
4. Insurance Assessment
run.
An important and often overlooked component of financial planning is to evaluate the kind of
insurance you need to protect yourself and your assets with your loved ones. Insurance types
• Enjoy a better standard of living Most people assume that they would have to
can include life, disability, health, vehicle, and property insurance to name a few.
sacrifice their standard of living if their monthly bills and EMI repayments are to be
Depending on your stage in life, your insurance needs (risk management needs) will change
addressed. On the contrary, with a good financial plan, you would not need to
and evolve.
compromise your lifestyle. It is possible to achieve your goals while living in relative
comfort.
5. Estate Planning
No matter your age, estate planning is an integral component of long-term financial planning.
• Be prepared for emergencies Creating an emergency fund is a critical aspect of
You can control the distribution of your assets, both during life and upon death, with the right
financial planning. Here, you need to ensure that you have a fund that is equal to at least
estate plan structures in place for your unique circumstances and wishes.
6 months of your monthly salary. This way, you don’t have to worry about procuring
Furthermore, keeping your estate plan current is just as important as creating it in the first
funds in case of a family emergency or a job loss. The emergency fund can help you pay
place.
for varied expenses on time.
6. Retirement Planning
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• Attain peace of mind With adequate funds at hand, you can cover your monthly help investors make the right investment choices. They also help with other aspects like
expenses, invest for your future goals and splurge a little for yourself and your family, insurance, retirement planning, estate planning and taxation.
without worry. Financial planning helps you manage your money efficiently and enjoy
peace of mind. Don’t worry if you have not yet reached this stage. If you are on the path • Monitor your financial plan regularly
of financial planning, the destination of financial peace is not very far away. The financial planning process does not end once you invest your money. You also need to
monitor how the funds are performing regularly. If they don’t perform, you may need to
replace them with better performing funds. You also need to follow your plan because as you
How to create a successful financial plan?
grow older, your goals and dreams evolve. For instance, your financial priorities may change
• Understand your current financial situation
after the birth of a child. Now, you need to accommodate the expenses and objectives of a new
Determine the status of your current finances, viz., your income, expenses, debt, savings and
member in your family.
investments. This is the first step in financial planning, as it gives you a good sense on the state
of your finances and ways to improve. Challenges to Behavioural Finance
Even when the rationalist model was on the ascent in the world of economics and finance, the
• Write down your financial goals
not-so rational aspects of human nature began to find its ways into economics. The major
Ask yourself: ‘what are the different financial goals I wish to achieve in life?’ Write them on a
challenges emanating from behavioural economics were in the form of:
piece of paper. Don’t hesitate to put down any goal because no goal is too small or too big.
However, make sure that your goals are specific. For instance, here are some achievable goals:
 Deviation from rationality
‘I want to purchase an SUV worth Rs. 13 lakh in the next 18 months’ or ‘I want to buy an
 Possibility of beating the market
apartment worth Rs. 80 lakh in the next 5 years.
 Divergence between market prices and fundamental values
• Look at the different investment options
 Pervasiveness of irrational forces
There are numerous investment options available to investors. In the mutual fund market
 Misleading signals from the market forces
alone, you can choose from nearly 2,000 schemes. Different investment avenues help investors
to achieve different goals. For example, equity funds are suitable for long-term goals like Many believe that this is because behavioral finance is able to explain how the market works. It
retirement planning, child’s education, etc. If you are interested in relatively steady income and offers some sense of control in a world that has become extremely volatile over an extended
you are risk averse, you may want to invest in debt mutual funds. period of time. However, the reality is that behavioral finance is nowhere close to perfect and
has its own sets of flaws as well. As an investor, it is important to know and understand those
Equity Linked Saving Scheme (ELSS fund) are good to save tax. When it comes to investing, flaws before making decisions which are largely based on behavioral finance.
many financial experts have highlighted the importance of mutual funds. Investing in these
funds consistently over a longer period can help you achieve your dreams and goals. Some of the main limitations have been listed down below:
• Implement the right plan Doesn’t Provide Alternatives: The theory of behavioral finance is basically a critique of the
You need to select the right investment option based on factors such as your goals, age, risk traditional finance theory. It does a good job of disproving the traditional finance theory. Its
appetite and investment amount. If you are unsure on the funds you need to select for your basic premise is that a normal investor cannot be considered to be the utility-maximizing
portfolio, you can avail the services of a financial advisor. These are certified professionals who rational person that is described in traditional theories. This is where behavioral finance is
correct. However, that does not mean it provides an alternative.
Page 38 of 41
There are no propositions made by behavioral finance theory. There is nothing that can be them social status. The entire rationale behind status based investing has been missed in
empirically tested to formulate a new theory. As an investor, you cannot really rely on behavioral finance.
behavioral finance. This is because investments cannot be made based on criticisms. In short
Disregards the Value of Emotions: Behavioral finance views emotions as biases. In other
behavioral finance, the theory explains everything which is wrong with traditional theories.
words, it views emotions as cognitive problems that need to be fixed over the long term.
However, it does not provide an alternative!
However, in reality, this is not the case. Emotions have been friends of human beings for a very
Reduces Confidence: Another big problem with behavioral finance theory is that it drastically long time. Emotions have guided human beings away from chaos and danger. They can be very
reduces investor confidence. After reading these theories, many investors have reported that useful at times. Investors should realize that they do not need to abandon their emotions.
they face difficulties while making decisions. This is because investors start second-guessing Instead, they should try to optimize them, i.e., take cues from them but make the final decision
themselves. Everything they used to believe in earlier now starts looking like a bias. Hence, in a cool, rational manner.
they are not really sure and cannot be decisive in the given moment. It is a known fact that
decisiveness is very important in investment decisions. Investments are all about time, and by
the time an investor is able to sort out their bias and gain confidence, the investment Upcoming areas of Research
Behavioral finance is a modern area of study in finance which aims to combine behavioral and
proposition may have changed completely.
cognitive psychological theory with conventional economics and finance to provide explanations for
Contradictory Inferences: In many cases, behavioral finance theories end up confusing the reasons why people make irrational financial decisions. The Efficient Market Hypothesis
investors as well. Sometimes they draw a conclusion that investors are risk-averse. In the same assumes that the competition between investors seeking abnormal profits drive prices to their
theory, they draw a conclusion that investors are overconfident. Practitioners of behavioral “correct” value. The EMH does not assume that all investors are rational, but it does assume that
finance try to defend their theory by saying that the same investor behaves differently under markets make unbiased forecasts of the future. In contrast the behavioral finance assumes that
different circumstances. However, it is highly unlikely that the same person is risk-averse as financial markets are informationally inefficient. Specific applications of behavioral finance can be
well as risk-seeking. This flies in the face of psychology as well as common sense. examined in phenomena like inflation and underpricing of IPOs. Behavioral finance theory holds that
markets might fail to reflect economic fundamentals under conditions of irrational behavior,
Not Applicable for Institutions: Another important point to note is the fact that most of the systematic patterns of behavior and limits to arbitrage in financial markets. Investors behave
biases mentioned in behavioral finance are only applicable to individual investors. Hence, they irrationally when they don’t correctly process all the available information while forming their
would apply to the market as a whole if the entire market was run by individuals. However, the expectations of a company’s future. When large group of investors share particular patterns of
reality is that institutional investors form the majority of the investing community in the behavior (irrational systematic behavior), persistent price deviations do occur. Behavioral finance
market. They do not face most of the individual biases since they are investing other people’s theory suggests that the patterns of overconfidence, overreaction and over representation are
money. The behavioral finance theory is able to explain the irrational behavior of individual common to many investors and such groups can be large enough to prevent a company’s share price
investors. However, it is not able to explain the irrational behavior of institutions. from reflecting economic fundamentals.2 When investors assume that a company’s recent
performance alone is an indication of future performance, they may start bidding for shares and drive
Ignores Impact of Social Status: Another important point is the fact that behavioral finance
up the price. The two observed phenomena are long term reversal in shares and short term
theory ignores the impact of social status on investment decisions. There are some investments
momentum. In the phenomena or reversal, high performing stocks in the past few years will become
which are made purely from the point of view of increasing social status. In such cases,
low performing stocks of the next few years. According to behavioral finance theorists, this effect is
investors do not care about the economic impact of such investments. Most real estate
caused by an overreaction on the part of investors. Momentum occurs when positive returns for
investments fall under this category. People purchase expensive real estate because it gives
stocks over the past few months are followed by several more months of positive returns.
Page 39 of 41
Types of Ethical Investments
In recent years, many researchers in the area of finance and investment have been very active in
1. Socially Responsible Investing Funds (SRI Funds)
behavioural finance, and many of their research works have been accepted in the top journals in the
field of financial economics (Henker, Henker, & Mitsios, 2006). This shows that behavioural finance SRI funds avoid investing in controversial areas such as gambling, firearms, tobacco, alcohol, and
(Huang Jim Yuh, 2015) is becoming an increasingly significant area for research. oil. Here, the investor’s moral value is given critical importance in investment selection.
2. Environmental, Social and Governance Funds (ESG Funds)

Behavioural Finance is one of the dynamic and fully developed fields which have its own principle
and methodology (Redhead, 2008). Behavioural finance came in existence due to limitations of Unlike SRI funds, ESG funds consider in their decision-making how environment, social and
traditional theories and finance to support the investment and saving decisions (De Bondt & Thaler, governance risks and opportunities can cause material impacts on a company’s performance. They
1985; Werner DeBondt, 2010). While traditional finance formulates the investment strategy whereas can invest in sustainability while maintaining the same level of returns as they would with a standard
behavioural finance focuses on the decision process of its execution (MacKenzie, Fabian, & Lucia, approach.
2006). Many of the key variables in behavioural models are neither observable nor measurable 3. Impact Funds
directly to researchers analysing data, thus most of the empirical studies in the field of behavioural
Impact funds place equal importance on fund performance. Hence, they aggressively look at creating
finance adopt proxies in attempt to capture or measure the effect of such variables (Darren, 2015).
ethical changes supporting companies that provide certain products and services. Impact funds are
suitable for investors who are socially responsible but also want good returns.
Behavioural finance is one of the significant areas of research as many of the papers are new and
emerging in nature and have limited review papers. With consolidation of financial market across the 4. Faith-based Funds
world the importance of behavioural finance is attracting many scholars and researchers. According
Faith-based funds only invest in stocks that follow religious values and ideals, and strictly exclude
to analysis of (Huang Jim Yuh, 2015), during the period 1995 to 2013, in this period of 20 years, the
investments that don’t fit the category.
study in the area of behavioural finance was in 124 journals and 347 articles in which 650 authors
were involved. Participation in this field is limited to from USA, Germany, Spain, England, China Advantages of Ethical Investing
Israel, Australia, but there are limited scholars from south East Asia economy like India.
 The investor feels happy when an ethical holding company performs well. They benefit
Ethical and Social Responsibilities in Investment emotionally and financially when the company shares their values.
 As more people invest in ethical funds, the investments can grow substantially in the future.
 Since ethical investing is gaining importance, it will encourage other businesses to improve
Ethical investing is an investment strategy where the investor’s ethical values (moral, religious,
their ethical practices to attract funding.
social) are the primary objective, along with good returns. With suspicious and illegal investment
deals on the rise, many investors are starting to insist that companies they invest in are socially Disadvantages of Ethical Investing
responsible. This means treating their employees with respect, creating healthy products, and
 As ethical investing is not a passive strategy, it involves a lot of research to ensure that it
services and keeping away from unethical business practices.
aligns with the investor’s values and beliefs.
Ethical investing is for investors who want to invest their money for noble causes. For example, if an  Ethical investing may not provide optimal returns; hence, the investor sacrifices financial
investor thinks that tobacco is unhealthy, then they would avoid companies that produce tobacco or gains for an ethical approach
own investments in tobacco-manufacturing companies.  The fees for ethical investing can be higher due to the research involved in identifying the
right investment.
Page 40 of 41
Does Ethical Investing Work?
One key aim of ethical investors is to avoid investing in companies that produce products that are
against the social, moral, and religious values of the investor. However, boycotting an evil company
by not investing in it doesn’t mean that money is not going to the company.
When an investor purchases a stock, the money goes to the seller of the stock, who is an individual
investor and not the company. The company only makes money when it issues new stocks like an
initial public offering (IPO). Hence, ethical investors are not punishing the evil companies.
Also, by boycotting a company, ethical investors are reducing the pool of potential shareholders
which may reduce the price of the stocks, this only makes it more attractive to unethical investors in
the market to buy the stock at these lower prices.
Ethical investing is beneficial to society; however, it needs to fulfill certain elements that are high
standards to achieve.
A successful business idea needs to be identified, which will help the world. For example, solar
panels are good examples of ethical investing. However, a funding solar panel company that pollutes
the environment through its manufacturing process is self-defeating.
If the investor is able to identify a business opportunity that will result in a positive impact on the
planet, then there needs to be “additionality” – a path by which the business can lead the company to
grow sustainably. However, it is difficult to achieve such an objective in the stock market.
Not investing in unethical companies doesn’t mean they will disappear, in fact they may continue to
flourish as other investors seeking high returns will always be available.
Sunil Kushwaha Page 12
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This course intends to provide the in-depth knowledge of behavioral finance This course intends to provide the in-depth

course intends to provide the in-depth knowledge of behavioral finance

Sunil Kushwaha Page 3 Sunil Kushwaha Page 4

4. Capital Asset Pricing Model

The Efficient Frontier

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In terms of business, the principal is considered to be a shareholder, while the agent is

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Causes of Agency Problems 2. Restrictions

 Imposing restrictions or abolishing negative restrictions is a good way to significantly

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UNIT 2: Behavioral Biases

Syllabus: Categorization of biases, Heuristics, Anchoring, Self-deception, Frame

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 Frame dependent biases: The decision process of financial practitioners is also

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Most of these researches reveal that overconfidence is an illusion of superior knowledge in

Sunil Kushwaha Page 7 Sunil Kushwaha Page 8

Sunil Kushwaha Page 9 Sunil Kushwaha Page 10

Sunil Kushwaha Page 11

Passive investors make good clients because they tend to trust

Active investors are more likely to get personally involved with

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an enigma but rather an explainable behavior phenomenon.

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Financial Planning Process

What are financial goals?

Why financial goals matter

How To Set Financial Goals: 6 Simple Steps

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What is Financial Planning?

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Sunil Kushwaha Page 4 Sunil Kushwaha Page 5

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2. Environmental, Social and Governance Funds (ESG Funds)

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