BEHAVIORAL FINANCE

LECTURE 3 & 4
WHAT IS IN TODAY LECTURE

Behavioral
Decision
Decision making
making errors
errors and
and biases
biases
Finance

07/1
4/20
INTRODUCTION

 It is a sub-field of behavioral Economics

 First time it was considered by Psychologist Deniel Kahneman and
Economist Vernon Smith.
 Both were awarded Nobel prize in 2002.
 It means that the investors do not behave rationally while taking their
investment decisions.
 Investment decisions means timing of buying, selling, or holding the
securities.
INTRODUCTION

 Psychological influence, cognitive error, biasness and emotions forced them to

behave in an irrational way.
 Investorsas a human being processes information using shortcuts and
emotional filters.
 It forced the investor for selling the winners and holding the losers (securities).
 So, behavioral finance is a discipline that attempts to explain and
understanding of how the external (cognitive errors) and emotions influence
the decision making process of investors.
INTRODUCTION

 It is the integration of inter-related fields namely

 Human Psychology – Cognitive process of human mind and
emotions.
 Economics and Finance – Profits and loss in form of returns.
 Sociology – Social behavior of human being.
 DECISION MAKING ERRORS AND BIASES

• Let’s explore some of the buckets or building blocks that make up behavioral
finance.
• Behavioral finance views investors as “normal” but being subject to decision-
making biases and errors.
• We can break down the decision-making biases and errors into at least four
buckets.
A. HEURISTIC BIAS

1. Representativeness in Decision making

 Decision based on rule of thumb (stereotypness) instead of
proper analysis of data.
 Detecting a pattern in data which is actually not there.
 Forecasting of future prices on the basis of Past returns.
 Drawing the conclusion on the basis of insufficient information.
2. OVERCONFIDENCE

Overestimation of self ability in predicting market

events.
Over belief in luck factor.
Overestimation of knowledge and underestimation
of risk factors.
Habitual of taking too much risk.
3. COGNITIVE DISSONANCE

Mental conflict that arise when evidence are

presented against the belief or assumptions of
investors.
4. REGRET AVERSION

Emotions experienced for not having made

the right decisions.
Feeling responsibility for loss.
5. CONSERVATISM/AVAILIBILITY BIAS

 Decision made on information that are easily available.

 Decision based on recent information rather than on the detailed
information from past data.
 Decision based on rule of thumb rather than bothering about
detailed and complex analysis of data.
6. FAMILIARITY BIAS

 A mental threat that treats the familiar things as better than the less
familiar things.
 Thus, investors try to invest in those brands or securities that name
has been recognized or heard by them.
 This mean that familiar securities ore preferred over unfamiliar
securities irrespective of their performance.
7. CONFIRMATION BIAS

 Investors’ desire to find information that agrees with their

existing with their existing view with their existing view while
that conflicts are ignored.
 More weights to information favoring the decision and less
weights to those opposing it.
8. MENTAL ACCOUNTING

 Different value to money from different sources.

9. ANCHORING EFFECT/BIAS

 The tendency to attach or anchor out thought to a

reference point even though it may have no logical
relevance to the decisions at hand.
 For example : Cricket match
B: FRAME DEPENDENCE

 Behavior and decisions of people depends on the way the information is

framed.
 The concept and information is presented in a manner that he can easily see
only that, whatever they want to show.
 What goes in - will goes out.
 When you like someone, everything looks nice about him/her. And when you
dislike anyone, everything looks irritating about him/her.
 Generally done by experts on TV/ Youtube.
C: EMOTIONAL AND SOCIAL INFLUENCE

 Emotional Influences
o Fear and Greed
 Sometimes you become so coward that do not invest in very good securities
which are available at very low price. And sell the good securities very early
which have very good potential growth (Fear).
 Sometimes you become so courageous and invest in very risky securities or
do not sell the securities you are already valued very high in the market
(Greed).
C: EMOTIONAL AND SOCIAL INFLUENCE

 Social Influences
o Desire of people to be part of groups.
o Over-reaction on both-good news as well as bad values.
o This share is owing to you, why it is not with you?
o Oh you have sold it, I am still bearing it.
D: MARKET INEFFICIENCY

 Overreactionof market on corporate news. Over sold on bad

news, and over buying of good news.
 Noise Trading: Trading of false signals or noise , not on
fundamentals.
 Chasing of Market trends.
 Following market stars.
HOW TO OVERCOME PSYCHOLOGICAL
BIAS
 Develop your own investment policy suitable to your objectives and
according to your constraints.
 Do not follow the tends, but fundamentals.
 Long term horizon.
 Don’t invest with borrowed funds.
 Proper portfolio diversification.
 Invest money carefully- Nothing is free.
 Periodically review your portfolio.
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