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Chapter 4 Behavioural Finance

Behavioral psychology
Behavioral psychology tries to bring answers to certain anomalies observed in financial markets/investor behaviours and which cannot be explained by using financial theory.

Behavioural finance
Behavioural finance integrates aspects of social science; mainly psychology and sociology to explain the behaviour of investors and the evolution of financial markets.

Behavioural finance
Explain why individuals do not always take decisions that maximize their expected utility OR why the evolution of stock prices cannot be explained by EMH

Section 1: Expected Utility Theory and prospect theory

Expected utility theory assumes that investors always act in a rational manner, by respecting the axioms of cardinal utility (comparability, transitivity, independence, measurability, and ranking) and by maximising expected utility.

To verify whether the maximisation of expected utility criteria is always applied when individuals take decisions in situations of uncertainty, experiments have been carried out. These experiments consist in asking a sample of individuals to choose between several lotteries. Through the experiments, it was proved that individuals do not always apply the maximisation of expected utility criteria.

Choose between L1 and L2

1 0.8 L2


L1 0


Choose between L1 and L2

Results of the experiment show that: 80% of the individuals choose L1; i.e. L1 > L2

Choose between L3 and L4

3000 0.25

4000 0.2

L3 0.75 0


Experimental results
Choose between L1 & L2 80% of the individuals participating to experiment choose L1; i.e. L1 > L2

Choose between L3 & L4 65% of the individuals participating to experiment choose L4; i.e. L4 > L3

L3 = 0.25L1 + 0.75L5 L4 = 0.25L2 + 0.75L5

With L5 = (0,1)
According axiom independence: If L1 > L2 then L3 > L4 From experiments: L4 > L3


Conclusion Individuals do not always behave in a rational manner.


How to choose between lotteries: L1 & L2 OR L3 & L4 ??

Use expected utility theory

E.g. assume utility function: U (X) = X Concave EU (L1) = 1*3000 + 0 = 54.7723 L1 > L2 EU (L2) = 0.8*4000 + 0 = 50.5964

EU (L3) = 0.25*3000 + 0 = 13.6931 L > L 3 4 EU (L4) = 0.2*4000 + 0 = 12.6491


E.g. assume utility function: U (X) = X2 Convex U (L1) = 1*30002 + 0 = 9 000 000 L2 > L1 U (L2) = 0.8*40002 + 0 = 12 800 000 U (L3) = 0.25*30002 + 0 = 2 250 000 U (L4) = 0.2*40002 + 0 = 3 200 000
Maximisation respected of expected utility

L4 > L3
criteria not

Attitude of the majority of individuals participating to the experiment: - L1 > L2 Same decision as experiment is obtained from utility function U (X) = X (concave); therefore individuals are averse towards risk. - L4 > L3 Same decision as experiment is obtained from utility function U (X) = X2 (convex); therefore individuals are attracted towards risk. 15

According to expected utility theory, an individual will have only one utility function, either: - Concave or Convex or Linear
However from the experiment, it is demonstrated that depending upon the lotteries, the same individual/s can adopt different attitudes towards risk. Therefore the same individual/s will have different utility functions.

High probability associated with gains and low probability to losses: averse towards risk Low probability associated with gains and high probability associated to losses: Attracted towards risk Shows that individuals are less willing to gamble will gains (averse to risk) than with losses (attracted to risk).

Prospect theory
Because of contradictions in the expected utility theory, other methods were developed to enable individuals take decisions in situations of uncertainty. Among these methods, one of the most popular is prospect theory, which was developed by Kahneman and Tversky in 1979.

Prospect theory
It is a theory developed by psychologists, which is being applied in finance. In expected utility theory, there is only one utility function to evaluate the utility of all outcomes (gains/losses). In prospect theory, there are two utility functions, one function for gains and another for losses.

Utility functions under prospect theory

The utility function for gains will be concave and the utility function for losses will be convex. This shows that individuals are averse towards risk when gains are considered and attracted towards risk when losses are considered.


For losses individuals are attracted towards risk.

E.g. two individuals must choose from a set of risky investments/lotteries. One individual has just undergone a loss and the other a gain; the individual who has made the loss would normally be more risk averse as compared to the other individual who has made a gain. The risk averse individual could allocate more importance to the losses as compared to the gains when analysing the investments

0.9 0.9



0.1 0 E (L) = -900000 CE = -850000 (refuses) Risk attracted


E (L) = 900000 CE = 850000 (accepts) Risk averse

Prospect Theory (Kahneman and Tversky) Initial wealth/amount paid to participate to lottery = Rs1000 (reference point) Lottery = (500, 1500; 0.5, 0.5) Therefore Rs500 would be a loss and Rs1500 would be a gain.


Two utility functions: - One utility function for gains [U+ (xi)]; Defined as a concave utility function; showing aversion towards risk. - Another utility function for losses [U (xi)] Defined as a convex utility function, attracted towards risk. Probabilities converted to weights: w(p1), w(p2) ...

Evaluating lottery with expected utility theory: E U(L) = p1U(x1) + p2U(x2) + p3U(x3) + ... Lottery = (500, 1500; 0.5, 0.5) E U(L) = 0.5U(500) + 0.5U(1500) Evaluating lottery with prospect theory:

V (L) =

i 1

w( pi ) U

( xi )

i n 1

w( pi )U ( xi )

V (L) = w(0.5) U (500) + w(0.5) U+ (1500)


By applying prospect theory it can be proved that for the sets of lotteries in the example:

V (L1) > V (L2) L1 > L2 and V (L4) > V (L3) L4 > L3

Therefore prospect theory is able to explain the choice of investors under uncertainty.


Section 2: Efficient Market Hypothesis and anomalies

According to Market efficiency, stock prices should move in a random manner over time; as all information available is being integrated in stock prices at all instants. Information relative to past events or anticipated future events (e.g. in the past company had good financial results and it is anticipated that the future performance will be good: increase in stock price) and actual situation within the company or economy are integrated in the stocks prices

There are also unanticipated future events, which are integrated in stock prices and make them move in a random manner. Market efficiency also implies that stocks are fairly priced (stock value = market price of stock) and no investor can make gains in a consistent manner.

To test whether market are really efficient, 3 forms of market efficiency have been defined 29

Weak form
Weak form: If past stock prices could be used to predict future stock prices, then there should be a pattern in the evolution of the stock prices. Serial correlation of stock/security prices: Studies (Fama 1965) have shown that there is a very small positive correlation (approaching zero) between daily stock prices. That is the stock price at time (t+1) is not related to the stock price prevailing at 30 time t.

Semi-strong form
Semi-strong form: public information, (e.g. company publishes earnings figures or dividend payments) should be integrated in the stock price at the moment it is released.


Semi-strong form
Event study: researches have taken similar events (e.g. merger announcements; dividend payments) and studied how the stock prices of the companies had been affected by the events. If public information is instantly reflected in stock prices, then around the announcement date of the information an impact should be noted on stock price.

Strong-form: public and private information (internal information which is possessed by those who manage the company) must be reflected in stock prices.


Efficacy of professional investors (e.g. mutual funds who are in possession of internal information on the company): researches have shown that they do not generate superior returns to market indices. As private information is already integrated in stock and cannot be used by professional investors to make gains. (Consistent manner)

Over the years, many researches have studied the efficiency of stock markets and through the tests performed (as detailed above); they have been able to prove in many cases that markets are really efficient. However there exist a few events in financial markets which cannot be interpreted by using the efficient market hypothesis.


Crashes and Anomalies

1987 Crash and the Bubble

On 19th October 1987, the Dow Jones Industrial Average (DJIA index) fell by % in one day.

Other indexes in the world also had sharp decreases.


Why sharp fall in the indexes? EMH: an unfavorable information being integrated in the stock prices would cause decrease in stock price and index. However on the 19th of October, there was no few fundamental information to justify the sharp falls in the indexes. EMH not able to justify the market crash.
38 Bubble Between 1995 and 2000, the NASDAQ Composite Index rose by 580%. In November 2001 the index fell by 64%. What caused this sharp increase??? Behavioural finance: - It is the optimism of individuals on the future of the stocks that caused the index to rise. - As the individuals generated profits, their optimism was further increased. 39

The sharp rises and subsequent sharp decrease in indexes could not be explained by efficient market hypothesis. The economic and financial conditions prevailing when the crashes occurred (no consequent rise in gross domestic product or corporate profits) could not be used to explain the evolution of the stock prices within the indexes.


NASDAQ is composed of technology stocks. It has been put forward as argument that it is the enthusiasm of the investors about the future of the technology stocks, which could have caused the relatively high increases in the index. As potential investors observed other investors who had made profits from technology stocks, they were motivated into investing in these stocks, thus driving their prices up.

According to EHM stock prices follow a random walk; therefore it should be impossible to predict changes in stock prices based on publicly available information and on past price behaviour. According to market efficiency (weak form), there should be no pattern in the evolution of stock prices. However in reality some patterns have been noted.

January stock returns higher than in any other month. Returns Monday effect: stock prices tended to go down on Mondays.


January effect
Studies carried out in several stock markets have shown that for no particular reason, the return offered by stocks during the month of January is superior as compared to the other months. For example a study carried out on the NYSE over several years has shown that the average return for January is equal to 3.5% and the average return for the other months is equal to 0.5%.

January effect
Investors who are aware of this fact would be willing to buy and hold stocks e.g. in December, so as to benefit from the high returns in January.


Monday Effect
As stock prices move in a random manner, that is there is an equal probability of increase and decrease in stock price on any particular day of the week. The expected return (obtained from the change in stock prices; e.g. stock bought today (at S0), its return over period t would be [(st S0)/ S0]) on a given stock should be the same for Monday as it is for the other days of the week.

Monday Effect
Studies have shown that the average return on Monday was much lower than the average return on other days. A study done on the NYSE of a certain number of years have shown that on Mondays the average return was equal to -0.2% and on the other days the average return was positive (e.g. Tuesday = 0.02%; Wednesday = 0;1%...).

Holiday effect
A study found that average stock returns on trading days before public holidays are abnormally high (9/14 times higher than daily average return).


Few explanations from Behavioural finance

Investors are not identical and would not respond in the same manner to the same set of information, unlike what is assumed by efficient market hypothesis. Several theories have been developed, mainly based upon human psychology, to explain anomalies observed in financial theory.


Examples of a few theories: Individuals usually give more weight to recent events and give less importance to other information, when taking investment decisions. Biased expectations: people tend to be overconfident in their predictions of future stock prices.


People also tend to hold stocks that are generating losses for a longer time, expecting that the stock prices may improve. They also have a tendency to sell stocks that are generating gains too early out of fear that stock prices may start to decrease.