Behavioral Finance

BEHAVIORAL FINANCE
 BEHAVIORAL FINANCE
• "The investor's chief problem, and even his
worst enemy, is likely to be himself."

• "There are three factors that influence the

market: Fear, Greed, and Greed."
• Psych yourself up and get a good
understanding of:
• 1. Behavioral finance.
• 2. Some implications
 BEHAVIORAL FINANCE, INTRODUCTION
• Sooner or later, you are going to make an investment decision
that winds up costing you a lot of money.

• Why is this going to happen?

– You made a sound decision, but you are "unlucky.“
– You made a bad decision—one that could have been avoided.

• The beginning of investment wisdom:

– Learn to recognize circumstances leading to poor decisions.
– Then, you will reduce the damage from investment blunders.
 BEHAVIORAL FINANCE, DEFINITION
• Behavioral Finance The area of research that
attempts to understand and explain how reasoning
errors influence investor decisions and market prices.
• Much of behavioral finance research stems from the
research in the area of cognitive psychology.
– Cognitive psychology: the study of how people (including
investors) think, reason, and make decisions.
– Reasoning errors are often called cognitive errors.
• Some people believe that cognitive (reasoning) errors
made by investors will cause market inefficiencies.
 THREE ECONOMIC CONDITIONS THAT LEAD TO
MARKET EFFICIENCY
• 1)Investor rationality
• 2)Independent deviations from rationality
• 3) Arbitrage
• For a market to be inefficient, all three conditions must be absent.
That is,
– it must be that many, many investors make irrational investment
decisions, and
– the collective irrationality of these investors leads to an overly
optimistic or pessimistic market situation, and
– this situation cannot be corrected via arbitrage by rational, well-
capitalized investors.
• Whether these conditions can all be absent is the subject of a
raging debate among financial market researchers.
CHARACTERISTICS OF BEHAVIOURAL FINANCE
 Heuristics:
• it refers to a process by which people find out things
for themselves, developing ‘rules of thumb’. This often
leads to other errors. Heuristics can also be defined as
the “use of experience and practical efforts to answer
questions or to improve performance”. The irrational
way markets act at times can be explained with the
help of heuristics. Interpretation of new information
requires identification and understanding of all
heuristics that affect financial decision making. Some
of these are anchoring, representativeness,
conservatism, etc.
 FRAMING:
• The perceptions of choices that people have are
strongly influenced by how these choices are framed.
It means choices depend on how question is framed,
even though the objective facts remain constant.
Psychologists refer this behaviour as a’ frame
dependence’. As Glaser, Langer, Reynders and
Weber(2007) show that investors forecast of the stock
market depends on whether they are given and asked
to forecast future prices or future return. So it is how
framing has adversely affected people’s choices.
 EMOTIONS:
• Emotions and associated human unconscious needs,
fantasies, and fears drive much decision of human
beings. How these needs, fantasies, and fears
influence financial decision? Behavioural finance
recognise the role Keynes’s “animal spirit” plays in
explaining investor choices, and thus shaping
financial markets (Akerlof and Shiller, 2009).
Underlying premises is that our feeling determine
psychic reality affect investment judgment.
 Applications of Behavioural Finance:
• Capital Asset Pricing Model (CAPM) and the
Efficient Market Hypothesis (EMH) are based
on rational and logical assumptions. These
theories assume that people, for the most
part, behave rationally and predictably.
Theoretical and empirical evidence suggested
that CAPM, EMH, and other rational theories
did a respectable and commendable job of
predicting and explaining certain events.
 BEHAVIOURAL FINANCE: SCIENCE OR ART

• Behavioural Finance as a Science:

• Science is a systematic and scientific way of observing, recording,
analysing and interpreting any event.
• Behavioural Finance has got its inputs from traditional finance which
is a systematic and well-designed subject based on various theories.
• On this basis behavioural finance can be said to be a science.
• The theories of standard finance also helps in justifying the price
movements and trends of stocks (Fundamental Analysis), the
direction of market (Technical Analysis), construction, revision and
evaluation of investors’ portfolios( Markowitz Model, Sharpe’s
Performance Index, Treynor’s Performance Index, various formula
and plans of portfolio revision)
 Behavioural Finance as an Art
• art we create our own rules and not work on rules of thumb as in
science.
• Art helps us to use theoretical concepts in the practical world.
• Behavioural finance focuses on the reasons that limit the theories of
standard finance and also the reasons for market anomalies
created.
• It provides various tailor made solutions to the investors to be
applied in their financial planning.
• Based on above behavioural finance can be said to be an art of
finance in a more practical manner.
• It also helps to guide the investors to identify themselves better by
providing various models of human personality.
OBJECTIVES OF BEHAVORIAL FINANCE
 Correct decision making
 Provide knowledge to unaware investors
 Identifies emotions and mental errors
 Delivering what the client expects
 Ensuring mutual benefits
 Maintaining a consistent approach
 Examining a consistent approach
SIGNIFICANCE OF BEHAVORIAL FINANCE

 Determining goals of investors

 Defines investors’ biases
 Manages behavioural biases
 Helps in investment decisions
 Helps for financial advisors’ and fund managers
 Signifies that investors are emotional
 Prospect theory
• Prospect theory provides an alternative to classical, rational
economic decision-making.
• The foundation of prospect theory: investors are much more
distressed by prospective losses than they are happy about
prospective gains.
– Researchers have found that a typical investor considers the pain of
a $1 loss to be about twice as great as the pleasure received from
the gain of $1.
– Also, researchers have found that investors respond in different ways
to identical situations.
– The difference depends on whether the situation is presented in
terms of losses or in terms of gains.
 INVESTOR BEHAVIOR CONSISTENT WITH PROSPECT
THEORY PREDICTIONS

• There are three major judgment errors

consistent with the predictions of prospect
theory.
– Frame Dependence
– Mental Accounting
– The House Money Effect
• There are other judgment errors that are also
consistent with the predictions of prospect
theory
1
2
 FRAME DEPENDENCE, I.
• If an investment problem is presented in two different
(but really equivalent) ways, investors often make
inconsistent choices.
• That is, how a problem is described, or framed, seems to
matter to people.
• Some people believe that frames are transparent. Are
they?
• Try this: Jot down your answers in the following two
scenarios.
 FRAME DEPENDENCE, II
• Scenario One. Suppose we give you $1,000. Then, you
have the following choice to make:
– A. You can receive another $500 for sure.
– B. You can flip a fair coin. If the coin-flip comes up "heads,"
you get another $1,000, but if it comes up "tails," you get
nothing.
• Scenario Two. Suppose we give you $2,000. Then, you
have the following choice to make:
– A. You can lose $500 for sure.
– B. You can flip a fair coin. If the coin-flip comes up "heads," you
lose another $1,000, but if it comes up "tails," you lose nothing.
FRAME DEPENDENCE, IV
 MENTAL ACCOUNTING AND LOSS AVERSION
• Mental Accounting: Associating a stock with its purchase price.
• If you are engaging in mental accounting:
• You find it is difficult to sell a stock at a price lower than your purchase price.
• If you sell a stock at a loss:
– It may be hard for you to think that purchasing the stock in the first place was
correct.
– You may feel this way even if the decision to buy was actually a very good decision.
– A further complication of mental accounting is loss aversion.
• Loss Aversion: A reluctance to sell investments after they have fallen in
value. Also known as the "breakeven" effect or "disposition" effect.
• If you suffer from Loss Aversion, you will think that if you can just somehow
"get even," you will be able to sell the stock.
• If you suffer from Loss Aversion, it is sometimes said that you have "get-
evenitis."
 THE HOUSE MONEY EFFECT, I.
• Las Vegas casinos have found that gamblers are far more likely to take
big risks with money that they have won from the casino (i.e., "house
money").
• Also, casinos have found that gamblers are not as upset about losing
house money as they are about losing their own gambling money.
– It may seem natural for you to separate your money into two buckets:
– Your very precious money earned through hard work, sweat, and
sacrifice.
• Your less precious windfall money (i.e., house money).
• But, this separation is plainly irrational.
– Any dollar you have buys the same amount of goods and services.
– The buying power is the same for "your money" and for your
"house money.
 OVERCONFIDENCE: A SIGNIFICANT ERROR IN
INVESTOR JUDGMENT
• A serious error in judgment you can make as an
investor is to be overconfident.
• We are all overconfident about our abilities in many
areas.
• Be honest: Do you think of yourself as a better than
average driver?
– If you do, you are not alone.
– About 80 percent of the people who are asked this
question will say "yes."
• How does overconfidence affect investment decisions?
 BEHAVIOURAL FINANCE IN THE STOCK
MARKET
• Understanding and applying behavioural finance biases to
stock and other trading market movements can be done
daily. Broadly speaking, behavioural finance theories have
been used to explain significant market anomalies such as
bubbles and deep recessions. Investors and portfolio
managers have a vested interest in knowing behavioural
finance developments, even if they are not part of EMH.
These patterns can be used to analyse market price levels
and fluctuations for purposes of speculation and decision-
making.
DECISION MAKING ERRORS AND BIASES
 i) Self-Deception:
• The concept of self-deception is a barrier to
learning. We tend to ignore the knowledge
that we need to make an informed decision
when we incorrectly believe we know more
than we do.
• ii) Heuristic Simplification: Another bucket that
we can look into is a heuristic simplification.
Information-processing errors are referred to as
heuristic simplification.
• iii) Emotion: Emotion is another behavioural
finance bucket. In behavioural finance, emotion
refers to our decision-making based on our
current emotional state. Our current attitude may
cause us to make decisions that are not based on
logic.
• iv) Social Influence: The social bucket refers to
how our decision-making is influenced by others.
 HEURISTICS AND BIASES OF
BEHAVIOURAL FINANCE
• 1. Representative
• 2. Anchoring
• 3. Overconfidence
• 4. Loss Aversion
• 5. Regret Aversion
• 6. Confirmation
• 7. Hindsight
• 8. Herding
• 9. Mentality Accounting
• 10. Gambler’s Fallacy
• 11. The Money Illusion
• 12. Experiential
• 13. Familiarity