Behavioral and Personal Finance

Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 01 : Introduction to behavioral economics and finance
 Foundations of finance
 Behavioral aspects of financial decision making
Foundations of Finance
Equity shares
• Securitized ownership
Debentures/Bonds (Debt)
• Securitized borrowings
Mixing and matching of assets
• Portfolio of assets/investments
Risk and return!!
Behavioral and Personal Finance
Abhijeet Chandra
Vinod Gupta School of Management, IIT Kharagpur

Module 01: Behavioral Economics and Finance

Lecture 02 : Introduction to behavioral economics and finance (cont.)
Foundations of Finance
Investment decisions
• To be (in the game) or not to be?
Financing decisions
• Where to get the money, honey?
Working capital decisions
• The show must go on!
Payout decisions
• Who will get the cheese?
 Modern Portfolio Theory
Homo Economicus
(Markowitz, 1952)
(Milli, 1844) Efficient Market
Capital Asset Pricing Model
Expected Utility Theory Hypothesis
(Treynor, 1962; Sharpe, 1964;
(Bernoulli, 1738, 1954) (Fama, 1970)
Lintner, 1965)

Behavioral
Approach
(vonNeumann Three-factor Models Pricing of Financial
-Morgenstern, (Fama-French, 1992) Derivatives
1944) Four-factor Model (Black-Scholes, 1973;
(Carhart, 1997) Merton, 1973)
Foundations of Finance
Why psychology matters?
Choose between the following:
A. A 50% chance of winning $100 (the gamble); or,
B. A sure shot gain of $50 (the sure thing).

Most of us go for: B
• Because we think of ourselves as conservative, and
• After all a bird in hand is worth two in bush, right?
• So, why gamble?
Foundations of Finance
Why psychology matters?
Now, choose between the following:
A. A 50% chance of loosing $100 (the gamble); or,
B. A sure shot loss of $50 (the sure thing).

Most of us prefer to go for: A

• Because we hate taking losses, and
• God forbid, we may turn lucky, right?
• So, why not gamble?
Foundations of Finance
Why psychology matters?
Conventional finance:
• Prices of assets are correct, i.e., equal to their intrinsic values;
• Resources are allocated efficiently;
• The world is fair, and so are the markets (Adam Smith’s Invisible Hand)

Behavioral finance:
1. People are Homo Sapiens, not Homo Economicus!
2. What if individuals don’t behave rationally?
Foundations of Finance
3 (or more) mistakes we might make:
Forecasting errors:
• Too much weight placed on recent experiences
• Ex.: Great Depression experiences, Tsunami in Chennai
Overconfidence:
• People overestimate their abilities and the precisions of their forecasts.
• Ex.: Driving skills survey, Stock market experiences

Conservatism:
• People are slow to update their beliefs and tend to underreact to new information.
• Ex.: Anchoring to prices, holding onto the losers.
Foundations of Finance
Behavioralising Finance:
• Conventional finance theory helps understand financial decision making with
certain assumptions.
• Decision makers suffer from biases and behavioral limitations.
• Biases lead to Suboptimal decisions.
• Finance theories with a flavor of psychology provides reasonably acceptable
explanations to real world financial phenomena.
• Understanding psyche of market participants makes much more sense.
• Helps in interpretations to financial crises and bubbles.