INSTITUTE –University School of Business

DEPARTMENT -Management
Program Name
Course Name: Behavioral Finance and Analytics
Course Code: 22BAA 754
Chandigarh University, Mohali

UNIT-2
DISCOVER . LEARN . EMPOWER

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 Learning Objectives Foundations of Finance

CO Title Level
Number Foundations of Finance –
CO1 To gain an understanding of the concepts Remember Standard and Behavioural
of behavioral finance.
CO2 Analyze psychographic models used in Understand
behavioral finance by retail investors for
investment decisions
CO3 To analyze the effect of different Understand
Behavioural influences on various
investment decisions
CO 4 Differentiating the different investors' Analyze
behaviour in Indian Financial Markets
using segmentation
CO 5 To evaluate investment decisions by Application
retail investors using emerging trends in
financial markets
Unit – II: Behavioral Factors explaining Stock Market Puzzles!!

CO3: To analyze the effect of different Behavioural influences on various

investment decisions.

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 Introduction: MERGERS AND ACQUISITIONS
• Survey evidence documents that overconfident managers appear to be
more active on the M&A front.
• Malmendier and Tate, in related research, investigate whether naturally
occurring data support this, and, if so, whether success results from this
heightened activity.
• To be sure, as a group, acquiring firms do not appear to serve their
shareholders: during 1980–2001, $220 billion was lost immediately after
bid announcements.

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Introduction: MERGERS AND ACQUISITIONS

• At the outset, it needs to be noted that it is not obvious that overconfidence

should lead to more mergers.
• The reason is that there are two conflicting motivations.
• First, most obviously, managers embodying this tendency will overestimate
synergies and their ability to stickhandle problems.
• This encourages merger attempts.

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• Referring to Figure 16.1, we see that in all but two years of their sample overconfident
managers engage in more M&A activity.
• Consistent with their previous study, the impact of overconfidence is greater for firms with
abundant internal resources.
• The market has a sense of the value destruction wrought by overconfident managers.
• While the typical market response to an announcement of a merger attempt engineered
by a less overconfident manager is a drop of 12 basis points, managers subject to an
inflated sense of their ability witness a (much larger) 90-basis point drop.

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• Various alternative explanations for these findings are considered.
• The same behavior could result from greater risk-seeking or agency (empire-building)
considerations.
• The authors, however, argue that the first is difficult to reconcile with an observed
preference for cash acquisitions; and
• the second is not easy to tally with CEOs’ personal overinvestment.

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• John Doukas and Dimitris Petmezas provide robustness checks along several dimensions.
• First, they investigate U.K. merger activity between 1980 and 2004, concentrating on the
acquisition of private firms.
• The United Kingdom is an appropriate market to investigate since it has, after the United
States, the most merger activity: indeed, 65% of European transactions occur there.
• Second, they utilize alternative proxies for overconfidence. One is based on the argument
that only egregiously overconfident managers engage in a spate of deals within a short
period of time.
• On this basis, they classify managers as overconfident if they complete at least five deals
within three years.
• They are able to conclude that overconfident bidders realize lower announcement returns
than their counterparts.
• Further, poorer long-term performance results.

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START-UPS

• It is well known that businesses, especially small ones, fail at an alarmingly high rate.
• One study reports that 81% believe their chance of success is 70% or better, while 33% are
sure (as incredible as this may seem) that they will succeed.
• It turns out though that 75% of new businesses fail within five years.
• A likely reason for such misguided expectations is overconfidence.
• Excessive optimism may mistakenly lead people to think that the market is crying out for
their goods and services, and a better-than-average effect may lead entrepreneurs to think
that, even if industry-wide opportunities are limited, they will still beat the odds.

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START-UPS

• Venture capitalists, whose expertise is in the realm of identifying profitable opportunities,

are also subject to overconfidence.
• As we have discussed before, overconfidence requires a proxy, and indeed several clever
ones have been used.
• But these require a track record or visibility, which many entrepreneurs do not possess.
• While it can be observed that entry seems to be excessive, it is not clear what the
characteristics of the entrepreneurs are who are entering an industry, and how they
compare to those who are staying out.
• So field tests are problematic.
• As we have mentioned previously, an experimental setting, in allowing for environmental
control, allows us to isolate factors of potential importance.

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START-UPS

• Colin Camerer and Dan Lovallo performed an experiment, where subjects had to choose,
over multiple rounds (periods), whether or not to enter markets.
• Payoffs to participants were dependent on the number of entrants in a given period.
• This is realistic since, in naturally occurring markets, payoffs are higher when fewer people
(or businesses) enter an industry.
• While the rules were known, the task was not easy since, given the noncommunicative
nature of the environment, no one knew how many competitors would also enter in a
given round.
• Previous experiments of this type had been conducted with the following setup.

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START-UPS

• An appearance fee was received by all participants.

• Suppose this value is $10. In the event of non-entry into the market, participants keep the
fee.
• Entry, on the other hand, risks losing some of (or all of) this fee.
• At the same time, a positive profit is possible as a result of entry.
• N players choose whether to enter a market in a given round; c is the market capacity; and
E the number of players who actually choose to enter.
• Then the profit function is specified as follows:
Profit = [$10/(N–c)]*(c–E)

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 START-UPS

• Then the profit function is specified as follows:

Profit = [$10/(N–c)]*(c–E)
• In these earlier formulations of the experiment, all of the “E” entrants earned the same payoff.
• Suppose c = 8 and N = 16.
• If E = 4, then the four entrants earn $5 each (taking home $15).
• Industry profit is $20 (4 * $5).
• On the other hand, if E = 12, then the 12 entrants lose $5 each, implying that industry profit is −
$60 (12 * (−$5)).
• Industry profit is zero if c = E. When such experiments were run, E was typically close to c, implying
the familiar zero-profit condition of microeconomics.

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Camerer and Lovallo made the following key adjustments to
incorporate overconfidence into this setting:
1. Profit depended on subjects’ ranks (r) in the following fashion:
a) the first c entrants in rank received:
Profit = $50 * [(c + 1 – r) / (1 + 2 + … + c)]; where r = 1; 2; 3…c
b) all entrants with rank lower than c received:
Profit = −$10
For example, given c = 3 and E = 12, we have:
r = 1: Profit = $25; r = 2: Profit = $17; r = 3: Profit = $8; r = 4; 5…12:
Profit = −$10

Note that if, as here, E > c+5, the industry profit is negative (here it is −$40).

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 Camerer and Lovallo made the following key adjustments to
incorporate overconfidence into this setting:
2. Subjects’ ranks depended on either a random device or skill, where skill was assessed after the
completion of the experiment using either brain teasers or trivia quizzes (involving current events
and sports).
3. Subjects in some experiments (but not all) were told in advance that the experiment depended
on skill. When told, subjects were consciously “self-selecting” into this environment.
4. Subjects forecast the number of entrants in each period.
5. Entry decisions were made in two rounds of 12 periods each, with ranking being skill-based in
one round and random in the other.
6. Market capacity was as follows: c = 2, 4, 6, and 8.

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Camerer and Lovallo made the following key adjustments to
incorporate overconfidence into this setting:
• Only at the end of the experimental sessions did subjects do their skill-testing
puzzles and trivia quizzes, after which one period (out of the 24) was randomly
chosen as the payoff period.
• The only feedback subjects received during the course of the experiment was
the number of entrants after each period.
• Assuming risk neutrality and no feelings of skill (or good luck) on the part of
participants, the mixed-strategy equilibrium is to enter a market randomly [(c +
5)/N]% of the time (which implies an expected overall profit of zero).

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• Table 16.3 provides the key results.
• The main issue under investigation is whether or not there is a tendency to enter a round
more freely when one’s profit is determined by skill.
• If people had a true picture of their skill relative to the skill of others, there would be no
impact.
• The reason is that, while those more skillful (and in knowledge of this) would be more
likely to enter, those less skillful (and in knowledge of this) would be less likely to enter.
• On balance, these tendencies should cancel out.
• Focusing on the column on the right, when regular instructions were used, the random-
versus-skilled differential profit was 8.96 (or 19.79 – 10.83), suggesting additional entry
when the payoff was to be determined by skill.
• The differential was even greater when self-selection instructions were used. In this case,
the random-versus-skilled differential profit was 27.92 (or 13.96 – (−13.96)).
• The overall average differential was a highly significant 18.43 (or 16.87 – (−1.56)),
consistent with the main hypothesis tested in the paper.

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• The fact that the differential was significantly higher under the self-
selection treatment was argued to be consistent with a reference
group neglect effect.
• Though this particular design was likely to lead to a more highly
skilled group volunteering to participate, this same group seemed to
forget the fact that others in the group were also more likely to be
superior in terms of skill and, for this reason, keen to “play the
game.”

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• One possible non-behavioral reason for excessive entry into markets that the authors were
able to eliminate is “competitive blind spots,” that is, the tendency to enter a market and
then be surprised by the amount of competition—without any feeling of great personal
skill.
• Such a view would lead to a prediction of positive profit in the skill treatments, implying
that the actual negative or low profits came as a surprise.
• The reality proved to be otherwise, as subjects consistently predicted higher profits for the
random periods than for the skill periods.
• Thus, while people expected low (or negative) aggregate profits in the skill rounds, they
expected that they themselves would do well.

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CAN MANAGERIAL OVERCONFIDENCE HAVE A POSITIVE SIDE?
• As we have suggested elsewhere, overconfidence may have a positive aspect.
• A moderate level of overconfidence could have a salutary side, if it leads to elevated,
concentrated effort.
• In the context of principal-agent theory, this can alleviate the moral hazard problem due to
the non-observability of the agent’s effort.
• Further, since managers can be more risk averse than shareholders might like,
overconfidence can counteract this tendency, moving the firm toward what is desirable.
• Aside from obvious potential impacts on investment, capital structure may also be
affected.
• Dirk Hackbarth has formulated a model where otherwise rational managers are not only
excessively optimistic about their firm’s prospects, but also overly sure about their views.

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CAN MANAGERIAL OVERCONFIDENCE HAVE A POSITIVE SIDE?
• This model suggests that managerial overconfidence is positively correlated
with debt issuance, because optimism about future cash flows leads to a belief
that there will be little problem in covering interest payments.
• Ironically, the natural tendency to shy away from debt because of job concerns
(which is value-destroying because the benefits of debt are not exhausted) is
counteracted by overconfidence

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• Finally, it has even been suggested that overconfidence among entrepreneurs,
even if personally deleterious, might be socially beneficial, because
entrepreneurial activity can provide valuable information to society (unlike
herders, who provide no information).
• In this sense, it serves a valuable evolutionary purpose.

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Variables Influencing
Individual Behavior

ThePPerson
• Skills & abilities
• Personality E
The Environment
• Perceptions • Organization
• Attitudes • Work group
• Values • Job
• Ethics • Personal life

B
Behavior

B = f(P,E)
 Propositions of
Interactional Psychology

• Behavior—function of a continuous, multi-directional interaction between

person and situation
• Person—active in process
• Changed by situations
• Changes situations
• People vary in many characteristics
• Two situational interpretations
• The objective situation
• Person’s subjective view of the situation
Definition of Personality

Personality - A relatively stable set of characteristics that influences an individual’s behavior

Personality Theories

Trait Theory - understand individuals by breaking down behavior patterns into observable
traits
Psychodynamic Theory - emphasizes the unconscious determinants of behavior
Humanistic Theory - emphasizes individual growth and improvement
Integrative Approach - describes personality as a composite of an individual’s psychological
processes
Big Five Personality Traits

Extraversion Gregarious, assertive,

sociable
Agreeableness Cooperative, warm,
agreeable
Conscientiousness Hardworking, organized,
dependable
Emotional stability Calm, self-confidant, cool
Openness to Creative, curious,
experience cultured

Sources: P. T. Costa and R. R. McCrae, The NEO-PI Personality Inventory (Odessa, Fla.: Psychological Assessment Resources, 1992); J. F. Salgado, “The Five Factor Model of Personality and Job
Performance in the European Community,” Journal of Applied Psychology 82 (1997): 30-43.
Personality Characteristics
in Organizations

Locus of Control
Internal External
I control what People and circumstances control my fate!
happens to me!
 Personality Characteristics
in Organizations
Self-Efficacy - beliefs and expectations about one’s ability to accomplish a specific
task effectively

Sources of self-efficacy
• Prior experiences and prior success
• Behavior models (observing success)
• Persuasion
• Assessment of current physical & emotional capabilities
Personality Characteristics
in Organizations

Self-Esteem
Feelings of Self Worth

Success tends Failure tends

to increase to decrease
self-esteem self-esteem
 Personality Characteristics
in Organizations

Self-Monitoring
Behavior based on cues from people & situations

• High self-monitors • Low self-monitors

• flexible: adjust behavior according to the • act from internal states rather than from
situation and the behavior of others situational cues
• can appear unpredictable & inconsistent • show consistency
• less likely to respond to work group norms
or supervisory feedback
Who Is Most Likely to . . .

Low-self High-self
monitors monitors
Get promoted
Accomplish tasks, meet other’s expectations, seek out
central positions in social networks 
Change employers
Self-promote 
Make a job-related geographic
move
Demonstrate higher levels of managerial self-awareness; 
base behavior on other’s cues and the situation
Personality Characteristics
in Organizations

Positive Affect - an individual’s tendency to accentuate the positive aspects of oneself, other
people, and the world in general

Negative Affect - an individual’s tendency to accentuate the negative aspects of oneself,

other people, and the world in general
Personality Characteristics
in Organizations

A strong
situation can
overwhelm the effects
of individual personalities
by providing strong cues
for appropriate
behavior
Personality Characteristics
in Organizations

Strong
personalities
will dominate
in a weak
situation
 How is Personality Measured?

Projective Test - elicits an individual’s response to abstract stimuli

Behavioral Measures - personality assessments that involve observing an individual’s behavior in a
controlled situation
Self-Report Questionnaire - assessment involving an individual’s responses to questions
Myers-Briggs Type Indicator (MBTI) - instrument measuring Jung’s theory of individual differences.
Myers-Briggs Type Indicator

• Based on Carl Jung’s work

• People are fundamentally different
• People are fundamentally alike
• People have preference combinations for extraversion/introversion, perception, judgment
• Briggs & Myers developed the MBTI to understand individual differences
 MBTI Preferences

Preferences Represents

Extraversion Introversion How one

re-energizes
Sensing Intuiting How one gathers
information
Thinking Feeling How one makes
decisions
Judging Perceiving How one orients to the
outer world
Social Perception

Barriers
• Selective perception • Projection
• Stereotyping • Self-fulfilling prophecies
• First-impression error

Social Perception -
interpreting information about another person
 Social Perception
Perceiver Characteristics Target Characteristics
• Familiarity with target • Physical appearance
• Attitudes/Mood • Verbal communication
• Self-Concept • Nonverbal cues
• Cognitive structure • Intentions

Social Perception -
interpreting information about another person

Barriers

Situational Characteristics
• Interaction context
• Strength of situational cues
Impression Management

Impression Management - process by which individuals try to control the impression

others have of them
• Name dropping
• Appearance
• Self-description
• Flattery
• Favors
• Agreement with opinion
Attribution Theory

Attribution theory - explains how individuals pinpoint the causes of their own behavior or
that of others

Information cues for attribution information gathering

• consensus
• distinctiveness
• consistency
Attribution Biases

Fundamental Attribution Error - tendency to make

attributions to internal causes when focusing on someone
else’s behavior

Self-serving Bias - tendency to attribute one’s own successes

to internal causes and one’s failures to external causes
 References
WebLinks
• https://people.bath.ac.uk/mnsrf/Teaching%202011/Cass%202010%20BCF.pdf
• https://corpgov.law.harvard.edu/2020/12/04/behavioral-corporate-finance-the-life-cycle-of-a-ceo-c
areer/
• https://www.nber.org/papers/w25162
• https://eml.berkeley.edu/~ulrike/Papers/Notes25jun2018.pdf
• https://people.stern.nyu.edu/jwurgler/papers/bcfsurvey2v20.pdf

References
• Ackert, L. and Deaves, R. (2115). Behavioral Finance. Ist Ed. Mason, OH: South-Western Cengage
Learning. ISBN: 978-0-324-66117-0.
• Pompian, M. 2106. Behavioral Finance and Wealth Management.Ist Ed. Wiley: New Jersey. ISBN: 0-
471-74517-0.

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