Behavioral Finance

Introduction

Gonçalo Sommer Ribeiro

Behavioral Finance Introduction

Behavioral Finance
Introduction
Teaching Team

• Gonçalo Sommer Ribeiro, CFA, CESGA

▪ Head of Structured Products @ BPI Bank

▪ Professional Investor for 12y + in Hedge Funds

▪ Consultant / Investment Advisor

▪ Experienced all biases

▪ Contact: goncalo.ribeiro@novasbe.pt

• Afonso Teixeira Duarte

▪ Behavioral Finance explorer

▪ Business Consultant at Deloitte

▪ Passed the CFA Level I and II

▪ Contact: afonso.duarte@novasbe.pt

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Behavioral Finance
Introduction
Practicalities

• Access:
▪ Moodle Enrolment Key: BFT424

• Classes:
▪ Monday 17h00 - 18h30, Room B 002

▪ Thursday 18h30 - 20h00, Room B 005

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Behavioral Finance
Introduction
Syllabus

• Understand human behavior and our limitations

▪ Cognitive

▪ Emotional

• Biases and Heuristics from individuals (Micro BF)

• Translate those biases and heuristics into market anomalies (Macro BF)

• Measuring impacts of biases and heuristics on performance

• Behavioral Asset Management

• Corporate finance influenced by human behavior

• Decision making impacts on Financial Markets and Corporate Finance

• Be aware of our limitations

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Behavioral Finance
Introduction
Purpose of the Course

• Games and experiments proofing our biases

• Quantify impacts on non-rational decision making

• Practical / Real Life Examples

• Learn how to think out-of-the-box, with more awareness

• Be better able do make informed decisions

• Capability to self-analyze and try to moderate our weaknesses

• Read other’s personality and feelings and mitigate their impact

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Behavioral Finance
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Assessment

• Weekly Quizzes (10%)

• Class Participation (10%)

• Two Group Assignments (4 students each)

▪ Case 1 (20%) due date, Monday the 29th of April, discussed in class
▪ Case 2 (20%) due date, Monday the 13th of May, discussed in class

• Exam (40%)

▪ Multiple-choice exercises, open end questions and mini-case studies solving

real-life situations. No minimum grade required.
▪ Saturday, 25th of May, 18:30

• Other Elements
▪ Participation in trading game & final self-report will earn +0.5 in final grade

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Behavioral Finance
Introduction
Literature

• Textbook
▪ Behavioral Finance and Wealth Management: How to Build Investment Strategies
That Account for Investor Biases, 2nd Edition, Michael M. Pompian
▪ Behavioral Corporate Finance (Mcgraw-hill/Irwin Series in Finance,
Insurance, And Real Estate) 1st Edition, Hersh Shefrin

• Other interesting books:

▪ Thinking, Fast and Slow, Daniel Kahneman
▪ Noise: A Flaw in Human Judgment, Daniel Kahneman, Olivier Sibony, Cass R.
Sustein
▪ Nudge: Improving Decisions about Health, Wealth, and Happiness, Richard
Thaler, Cass R. Sustein

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Behavioral Finance
Introduction
Definition

Behavioral finance is the intersection between the fields of psychology and Finance,
whereas human’s psychology and emotions influences their decision-making
processes

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Behavioral Finance
Introduction
Origins

• Behavioral finance is a sub-field of behavioral economics that specifically

attempts to explain financial market–related behavior and more recently also
helps explaining decisions made in the corporate finance field

• Behavioral economics (and thus behavioral finance) is a relatively new branch

of study that formally began in the 1980s and has garnered increasing attention
from economists and neuroscientists

• It was developed through an extensive empirical experiments research, which

treats individually of each human trait. This is one of the key criticisms to BF,
that it was only tested in the “lab” in a controlled environment and without
conjunction between experience

▪ Question is, if Traditional Finance has difficulties in describing a complex

world in formulas, how can Behavioralists model emotions?

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Behavioral Finance
Introduction
Noble Prize Winners

Physiology and Medicine

• Roger W. Sperry, Two Hemisphere Brain

Economics

• Daniel Kahneman, Prospect Theory

▪ Thinking, Fast and Slow book

• Richard Thaler, Nudge

▪ Nudge: Improving Decisions about Health, Wealth, and Happiness

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Behavioral Finance
Introduction
Our Brain
Experiment
Simon decided to invest $8,000 in the stock market one day early in 2008.
Six months after he invested, on July 17, the stocks he had purchased were down
50%.
Fortunately for Simon, from July 17 to October 17, the stocks he had purchased
went up 75%.

At this point, Simon has:

a. is ahead of where he began
b. broken even in the stock market
c. has lost money

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Behavioral Finance
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Our Brain
Experiment

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Our Brain

• The first research on the mater was published by psychobiologist and Nobel
Prize winner Roger W. Sperry, in the 1960s
• His theory says the brain’s two hemispheres function differently
• The impact on decision making is the impetuous right side of the brain will try
to answer questions quickly while its analytic left counterparty will try to go
through logic processes, causing a mismatch in answer timing and rationality

The left side: The right side:

▪ logic ▪ imagination
▪ sequencing ▪ holistic thinking
▪ linear thinking ▪ intuition
▪ mathematics ▪ arts
▪ facts ▪ rhythm
▪ thinking in words ▪ nonverbal cues
▪ feeling visualization
▪ daydreaming

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Behavioral Finance
Introduction
Decision Theory

• Decision theory is concerned with identifying values, probabilities, and other

uncertainties relevant to a given decision and using that information to arrive
at a theoretically optimal decision
• Decision theory is normative, meaning that it is concerned with identifying the
ideal decision
• The practical application of decision theory is prescriptive. It analyzes decisions
and attempts to provide tools and methods to help people make better decisions
• In practice, we humans usually take around 7000 decisions per day
▪ From clothing, to food, to our professional life's
• Some of those decisions are made in an instant, with our convictions, beliefs
and knowledge at that time, making them suboptimal and not fully rational
• Examples
▪ Golf is where big corporate decisions are made. What impact does it have in
managers?
▪ War decisions are taken in extremely stressful scenarios. What consequence does that
have?

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Behavioral Finance
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Traditional Finance
Assumptions
• Traditional Finance assumes Rational Economic Man (REM)
• Unlimited perfect knowledge
o Every investor fully understands finance concepts

• Utility maximization
o Every investor has the same utility function and maximizes that same
utility function

• Fully rational decision making

o Investors have no emotions

• Risk aversion
o Investors suffer a greater loss of utility for a given loss of wealth than
they gain in utility for the same rise in wealth

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Behavioral Finance
Introduction
Traditional Finance
Investment Perspective
• The price is right
o Assets reflect and instantly adjust to all available information

o Existence of a “fundamental” price

• No free lunch
o No manager should be able to generate excess returns (alphas) consistently

• Efficient Market Hypothesis (EMH)

o Weak-form efficient
o Semi-strong efficient
o Strong-form efficient

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Behavioral Finance
Introduction
Traditional Finance
Evidence against EMH

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Behavioral Finance
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Behavioral Finance
Assumptions
Behavioral Finance assumes

o Individuals are non perfectly rational and their decisions most probably
are be suboptimal

o Investors can be risk-averse, risk-neutral, risk-seeking at the same time

(same person buys insurance and lottery)

Bounded Rationality:
o Capacity limitation on knowledge

o Satisfice

o Cognitive limits on decision making

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Behavioral Finance
Introduction
Behavioral Finance
Assumptions
Investor psychology influences can create deviations from rationality, which
should be expected due to cognitive limitations, which can be characterized as
irrational behavior

More specifically cognitive psychologists have found experimental evidence that:

o How a decision is framed affects how that decision is made

o People have systematic cognitive biases that influence their beliefs and
their preferences, thereby affecting their decision-making (example of
Noise)

o People rely on rules of thumb (i.e., widely used principles) or heuristics

when making decisions, ignoring some important aspects related to the
decision

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Behavioral Finance
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Two different perspectives
Traditional Finance
• Most traditional financial and asset pricing models, such as the capital asset
pricing model, are based on two key assumptions:
▪ markets are frictionless, meaning there is no transaction cost to trade
▪ all investors are rational

• Rationality means that when new information is received, investors update

their beliefs appropriately and, given their beliefs, investors make choices that
are consistent with expected utility maximization, implying that they desire
higher expected returns and lower risk

• Traditional models assume that the markets adhere to the efficient market
hypothesis (EMH), in which market prices fully and immediately reflect all
relevant information and hence always equal a true fundamental, or intrinsic,
value

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Behavioral Finance
Introduction
Two different perspectives
Behavioral Finance
• Behavioral finance does not follow the same assumptions

• Behavioral finance simply observes how investors, financial managers, and

markets behave and then draws implications from the observed behavior

• This way, to accurately interpret empirical findings in finance, models should

consider market frictions and investors who are not fully rational

• Contrary to the assumptions of traditional financial models, investors do not

always update their beliefs appropriately and do not always maximize
expected utility

• Market prices do not always equal fundamental value. To understand these

irrational phenomena, two core areas have been identified, the behavioral
finance building blocks:
➢ limits to arbitrage
➢ investor psychology

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Behavioral Finance
Introduction
Two different perspectives
Limits to Arbitrage
Limits to Arbitrage – economic agents can have irrational behavior

Three main categories to justify the irrationality:

• Fundamental Risk – there is no such thing as “Fundamental” price, so buying

an asset based on a concept that is iterative (always evolving according to
different assumptions) its still risky

• Noise Trader Risk – investors trade based on random “noise” rather than
based on pertinent information

• Implementation Costs – implicit (bid-ask spread) and explicit (brokerage) costs

are effective costs to arbitrageurs. More costs can be considered, such as short-
sale constraints, margins requirements, legal constraints and the cost of finding
and exploiting arbitrage

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Resume

Traditional Finance Models Behavioral Finance Models

Assumptions: Observations:
• Markets are frictionless • Markets are not frictionless
• Investors are rational: • Not all investors are rational

▪ Behavior is consistent with ▪ Investor psychology:

expected utility maximization o Framing effects
▪ Beliefs are updated correctly o Biases
when new information is o Heuristics

received

Implications: Implications:

• There is no opportunity for arbitrage • There are limits to arbitrage

• Market price equals fundamental value • Market price does not necessarily
equal fundamental value
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Behavioral Finance
Introduction
Macro vs Micro BF

Micro Behavioral Finance

▪ Analyzes behavioral biases which distinguish individual investors from
totally rational economic beings – homo economicus – from neoclassical
economics
▪ Questions fully rational decision-making
▪ States that behavioral biases have a profound impact on decision-making
and can drive suboptimal decision making and errors that directly
contradict with traditional finance

Macro Behavioral Finance

▪ Analyzes market anomalies that distinguish financial markets from
efficient markets assumed by traditional finance
▪ At the same time questions this informational efficiency of markets
▪ States that financial markets are impacted by behavioral influences
(market anomalies, bubbles, excess volatility, limited arbitrage)

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Behavioral Finance
Concepts
Nudge

Nudge Definition: “altering people’s behavior in a predictable way without significantly

changing their economic incentives”

Nudge is a mechanism that makes it easier for people to choose the right
decision, without forcing them. Its psychology working in favor of society
behavioral changes

Examples:

• Savings in UK – opt-in and out-out pension fund system

• Taxes payment in UK – “most taxpayers pay their taxes on time, you are one
of the few yet to do so”

Literature: Nudge: Improving Decisions About Health, Wealth and Happiness, Richard
Thaler and Cass Sunstein

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Behavioral Finance
Concepts
Noise

Noise Definition: “unwanted variability within a system of judgments”

Noise is a term referring to volatility/dispersion around a decision making

process if it was continuously repeated. That dispersion reveals that the decision is
not optimal nor bullet proof, otherwise it would be always the same

Examples:

• Different judges sentences of the same case – meaning that people with
different backgrounds but with different information sets, make different
decisions when faced with the same problem

Literature: Noise: A Flaw in Human Judgment, Daniel Kahneman and Cass Sunstein

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