Paradox of Financial Decisions

and Emerging Behavioral Finance

Tradeoff between mind and heart
 Paradox
Situations Outcomes
• Good news • Price going down
• CA, CFA, FRM, observed bad • Price is going up
financials of company
• My wife in senior position, • Price going down
good export order, holds large
number of stocks of same firm
• Price going down
• FM speech positive, sops given
• Price is going down and losing
• NDTV profit….expert panel
constantly
opinion good
• Price up many times …sheer
• Dot com bubble
exuberance
 It seems
• Whole world is confused
• No one knows what to do
• It is ever changing and uncertain
• Hardly predictable
• In don’t understand, I would rather stay away
But we can’t leave stock market.
We have to catch the bull by the horn. Confront the
problem rather than run away from it.
 Confused client and advisor: both are at
cross roads
• Client Rs 70 lakhs
• 1998….invested in IT
• 2002……Portfolio Rs 3 crore
• Looking for advice, advisors told to sell
• 2004…portfolio…Rs 9 crore
• By the time he fell in love with stocks
• I lost clients by virtue of being conservative advisor
• 2007-08 came ….portfolio came to Rs 60 Lakhs
• I was embarrassed because I could not convince him to sell
• And he was frustrated and bewildered with the worst happening
 Conclusion
• Finance is important
• But understanding of behavior of investors,
agencies, market is equally important
• Empirical finance is purely a reference frame
• But calibration, adjustment with behavioral
aspects are inevitable
• Thus we need to understand in conjugation for
better decision making
 If investors do well, why do investors fare
poorly
• Analogy “ India is resourceful country but Indians are poor”.
• Equity, Index perform better than fixed income securities
• But we don’t get. Few may get abnormally high return and
few may get abnormally low return. This pattern may
change over time, Thus star players of yesterday may be
mute observers today. Why I learnt churning of portfolio?
• We want to apply mind, but we are overruled by our heart
• We may have higher intelligent quotient, but decisions are
taken by emotional quotient.
 Emotions change paradigm
• Dwarf and handicapped with blood cancer but
genius professor sitting on chair kept on high tables
score better than similar genius professor …..issues
of emotions
• Deprived and poor fellow singer score better than
similar singing art fellow
• Thus we are over-guided by emotions. Fair
performance + deprivation tilt out decisions
towards heart cum based decision making process.
 We are guided by
• We want to be rational and profit maximize
• But we become emotional and irrational impoverishing
our rational financial interest (birth day party, marriage
party, anniversary)….we make common mental mistakes
without realizing pure economic implications
• TIPS: we pay TIPS to insure prompt service.
• Thus behavioral finance is the study of how emotions and
cognitive errors can cause disasters in our financial affairs.
Thus we need to bridge the gap between classical theories
and behavioral theories for better decision making.
 Thus behavioral finance will guide us
• Long with stock which are crashing
• Short with stock which are rising
• Never look for right value and right time.
• You buy business not the stock
• You can buy time but you can’t time the market
• You may look for free lunch or arbitrage, but it is for
arbitrageurs not for you.
• Only free lunch in finance is “
diversification”….conditions apply.
 cont
• Exploit three sources of alpha
1. Exploit information………..by traditional
managers
2. Asset pricing models……quantitative
managers (discretionary portfolio)
3. Exploit behavior…..behavioral managers
Possible guiding path and what to choose

• Intellectual path ( asset pricing models)

• Physical path (Newspaper, NDTV profit, expert
panel, analyst meet and so on)
• Emotional path (behavioral finance)