BEHAVIOURAL FINANCE

Spring 2018
OVERALL AIMS OF COURSE

 The study of alternative financial and investment

research into cognitive biases, heuristics, emotions,
crowd behavior, and stock market psychology. The
course examines the applications of these theories in
corporate finance, personal finance, and investment
management and suggests approaches in which financial
managers and investors improve their intuitive and
analytical decision-making skills
TEXT BOOKS
 Behavioral finance psychology , decision making
and markets by Ackert and Deaves
 Behavioral corporate finance by Shefrin (2005)

 Psychology of investing , 4th edition by Nofsinger

(2010)
 Behavioral finance : investors , corporations , and
markets ( Robert W. Kolb Series ) by Baker and
Nofsingr (2010)
 Behavioral finance and investor types : Managing
behavior to make better investment decision by
Pompian (2012).
CONTENTS
Wks Topic
One • Introducing what is behavioral finance and exploring some important
Terminology in Behavioral finance.
• Traditionnel / standard finance versus behavioral finance
Two • Expected utility theory vs prospect theory.
• Practicing case studies
Three • Heuritics and Biases
• Overconfidence
Four Ch. 8 : Implications of Heuristics and Biases for Financial Decision –Making.
Five Ch. 9 : Implications of overconfidence for Financial- Decision Making.

six Ch15: Mispricing and the Goals of Managers ( Examples of Managerial actions
taking advantage of mispricing )
Six Ch15: Irrational Mangers or irrational investors ?
Seven Mid Term Exams
Eight
Nine Ch. 16: capital budgeting: Ease of processing, loss aversion and affect.
Ten Ch.16: Managerial overconfidence , Investment and Overconfidence
Eleven Ch. 19 : Money management : behavioral investing
Twelve Ch 19: is it possible to enhance portfolio performance using behavioral finance ?

Thirteen Determinants of capital structure and behavioral finance

Fourteen Discussing results of behavioral academic papers
WHY BEHAVIORAL FINANCE ??
 Talking about modern finance we are talking about the
type of finance that is based on rational and logical
theories , such as CAPM and EMH . These theories
assume that people behave rationally and predictably.
 but the real world proved to be a very messy place in
which market participants often behave very
unpredictably.
KEY CONCEPTS

 Anchoring (example: Diamond ring )

 Herd behavior

 Overconfidence : overestimating or exaggerating one’s

ability to successfully perform particular task .
COMPARISON OF BEHAVIORAL FINANCE AND
TRADITIONAL FINANCE: FOR INVESTMENT
DECISIONS

Behavioral finance is a relatively new field that seeks to

combine behavioral and cognitive psychological theory
with conventional economics and finance to provide
explanations for why people make
irrational financial decisions.
TRADITIONAL VS BEHAVIORAL
Traditional finance
 Assume : investors are knowledgeable , rational and they
act smartly in financial markets and they are not diverted
by their emotions or feelings and thy have perfect
information.

Behavioral finance
 Showed the above assumptions doesn’t match with realty
.
 It has become growing because of the observation that
investors rarely behave according to these assumptions.
CONCEPT OF BEHAVIORAL FINANCE

Phycology Sociology

Behavioral finance

Maximizing profits
EXPECTED UTILITY THEORY
 It was developed by John Neumann and Oskar
Morgenstern in an attempt to define rational behavior
when people face uncertainty.

 This theory was set up to deal with risk not uncertainty ,

 Difference between uncertainty and risk ???

CLASSICAL ECONOMIC THEORY
RATIONAL EXPECTED UTILITY
 We look at the “traditional” economic model of
consumer choice, which seeks to describe how people
are expected to behave when making financial decisions.
 This traditional model assumes that individuals are

rational, and that they make decisions in ways that

maximize their expected “utility” (or “happiness”) from
money made or lost.
UTILITY MAXIMIZATION
 Utility theory is used to describe preferences.
 To arrive at the optimal choice , an individual considers
all possible bundles of goods that satisfy his/ her budget
constraint ( based on wealth or income ).and then
chooses the bundle that maximize her utility.
TERMINOLOGIES
 Normative theory : says that reasonable people should
act in a certain way . ( expected utility theory )
 Positive theory : looks at what people actually do
( prospect theory)
 Risk : is one in which you know what the outcomes
could be and can assign probability to each outcome .
 Uncertainty : when u cannot assign probabilities or even
come up with a list of possible outcomes
Risk is measurable using probability , but uncertainty is
not.
RISK AVERSION
LOSS AVERSION
THINK WHY ?????
 Why are we inclined to sell the shares in our portfolio that
are performing well, and hold onto those that are performing
poorly?
 Why should you always buy auto insurance and never buy
electronics insurance?
 Why do we over-estimate the probability of plane crashes
and under-estimate the probability of car crashes?
 Behavioral finance provides insight into questions like these.
All of us have innate psychological biases that can lead to
predictable “errors” in how we make important financial
decisions. Behavioral finance catalogues these errors and
helps us to anticipate, and hopefully avoid, these decision-
making “traps.”
 PRACTICE 1
Differentiate the following terms and concepts :
 Risk aversion , risk seeking and risk neutrality .

 Risk and uncertainty

 When eating out , Rory prefers spaghetti over a

hamburger . Last night , she had a choice of spaghetti
over cheese and she decided on spaghetti again. The
night before , she had a choice of spaghetti , pizza, or a
hamburger and this time she had pizza . Then today she
chose cheese over hamburger . Does her selection today
indicate that Rory’s choice are consistent with economic
rationally ? Why or why not ?
 In behavioral finance , prospect theory proved useful to
economics however , because it attempts to model the
way people actually make decisions as opposed to
simply relying on the utility decision – making strategies
that made up finance theory .

 prospect theory argues that people make decisions based

on potential value of gains and losses rather than the
utility of the decisions.
GAINS AND LOSSES VS ABSOLUTE
WEALTH
DISPOSITION EFFECT
 If you picked (A) in the first game, and (D) in the second,
you are in very good company: this pair is the most
commonly selected combination
 Note, however, that the outcomes in the combination (A)
and (C) are identical: in both cases, you walk away
$40,000 richer.
 Similarly, (B) and (D) are identical: together, they generate
a 50% chance of either $30,000 or $50,000.
 This preference “switch” is known as the Disposition
Effect. Why do so many people “flip” their preferences? If
they selected (A) in Game 1, why not stick with (C)
(which has identical outcomes in all scenarios) in Game 2?
THE DISPOSITION EFFECT AND
INVESTING
 The Disposition Effect is the tendency for individuals to
be risk averse over gains, but risk seeking over losses.
 In the context of investing, this means we are inclined to
sell our winning investments, but hold onto investments
that are falling in value.
 When investing in the financial markets, we should try to
reverse both of these tendencies
THE DISPOSITION EFFECT AND
INVESTING
We should Run Gains
 Over the long run, risky investments go up on average

 Hence we should run gains, not sell them to convert the gains into
cash

We should Cut Losses

 We are inclined to hold onto losing positions, in the hope that the
price will go back to where we purchased it .
 But there is nothing special about the price at which you personally
purchased the position (stock prices have no “memory”); so clearly
it’s irrational to use your purchase price as a level at which to sell.
 Furthermore, if you need to liquidate some risky positions to obtain
cash, it is better for tax purposes to sell losers (or a combination of
winners and losers) to prevent paying capital gains tax
HOW TO AVOID “RISK SEEKING OVER
LOSSES”
“Many clients…will not sell anything at a loss. They don’t
want to give up the hope of making money on a particular
investment, or perhaps they want to get even before they
get out. This disease has probably created more destruction
on investment portfolios than anything else…”
much preferable
“When you suggest that the client close at a loss…The
words that I consider to have magical power in the sense
that they make for a more easy acceptance of the loss are
these: ‘Transfer your assets.’ ”
REGRET THEORY AND OMISSION BIAS
Case study : A flu epidemic has hit your community. This
flu can be fatal for children under the age of three. The
probability of a child getting the flu is 1 in 10, and 1 in 100
children who get the flu will die from it. This means that,
statistically speaking, 10 out of each 10,000 children in
your community will die.
A vaccine for this type of flu has been developed and tested.
The vaccine eliminates any chance of getting the flu. The
vaccine, however, has potentially fatal side effects. Suppose
that the vaccine has a 0.05% fatality rate; that is, the
vaccine itself is fatal in 5 out of every 10,000 cases. You
have a two-year old daughter. Will you choose to vaccinate
her?
 Many people respond NO to this question, despite the
fact that the child has a better survival rate with the
vaccine than without it.
 Regret Theory: posits that we make some decisions in
response to the extent of our anticipated regret if the
decision subsequently goes against us.
 Anticipated regret may be affected by Omission Bias: we
would prefer not to be the active agent of our child
becoming fatally ill.
If she becomes ill from the vaccine, we blame ourselves
because we gave it to her
If she simply catches the disease in the community, the
disease can be blamed on an “act of God”
OMISSION BIAS
 Is characterized by our tendency to feel worse about
negative outcomes that resulted from action vs inaction .
SUMMING UP SOME CONCEPTS
 LOSS AVERSION :
is characterized by feeling worse about losses than one feels
good about similar sized gains .
 RISK AVERSON :

is characterized by a tendency to prefer the sure thing vs the

risky gamble with the same expected outcome.
 RISK AVRSION OVER GAINS :

implies that receiving partial payments give more satisfaction .

 RISK SEEKING OVER LOSSES:

is the tendency to hold onto losing positions , in the hope that

the price will go back up to original price
CLASS WORK 1

Have fun 
RESEARCH TERM PAPER:

 Students write an extensive research paper on a specific

theory, topic or concept within the behavioral finance
literature. An outline is provided during the semester of
the exact requirements. Students submit a one-page
outline on a topic in which, I will approve the topic area
and provide feedback.
 Research paper must include (Title, Abstract,
Introduction, Methodology, Results, Discussion,
Conclusion, References)
BEHAVIORAL FINANCE TOPICS
 Group work ( from 3 to 5 )
Topics that will be summarized
1) Behavioral Finance : The Emergence and development
trends .
2) Behavioral patterns as determinants of market
movements : evidence from emerging markets .
3) The irrationality of markets .
4) History of behavioral finance .
5) The end of behavioral finance.
CHAPTER 5 : HEIRITICS AND BIASES
 Perception : people see what they expect to see .
 Memory : a retrieval of stored information in the brain .

 Framing effect : a decision – maker’s view of a problem and

its possible outcome .
 The primacy effect : the tendency to rely on information that
comes first when making an assessment.
 The recency effect : the tendency to rely on the most recent
information when making an assessment.
 Halo effect : the tendency to base an assessment on earlier
impression or salient characteristics.
 Ease of processing and information overload , a state of confusion
and decision avoidance induced by a large amount of information
that is difficult to assimilate .
HEURISTICS
 Decision rules that utilize a subset of the information set
and that sometimes lead to bias.
 Type 1 heuristic : heuristic appropriate when a very quick
decision must be made or when the stakes are low .
 Type 2 heuristic :heuristic that are more effortful and that are
appropriate when the stakes are higher.
Some heuritics influence preference through comfort seeking .
Examples are :
Familiarity: comfort in what is known .
Ambiguity aversion : the tendency to prefer risk ( with a known
probability distribution over outcomes) over uncertainty .
Diversification heuristic : the tendency to choose a bit of every
thing.