Behavioural Finance

Jindal School of Banking and Finance

Spring, 2024
What is Behavioral Finance

 Critiquing Economics/Finance using psychology.

 Use of mental faculties is a costly resource.
 Most of the time we make decisions by instinct, habit, and
laziness.
 As such we make systematic errors that are predictable
yet not fully preventable.
Economics and finance today …

 The Advent of Homo Economicus: In policy and individual thinking.

 If people act rationally we have powerful results justifying free markets etc.
 However, it is easy to demonstrate the fallibility of the rationality assumption.
The video test:

 https://www.youtube.com/watch?v=vJG698U2Mvo

 https://www.youtube.com/watch?v=_bnnmWYI0lM
Behavioural Economics
 Psychologists and behavioural economists study economic decisions
taken without rational thought.
 They provide a framework to make sense of our choices without
resorting to the restrictive but extremely convenient rationality
assumptions.
 Today the field of behavioural economics has already been awarded two
Nobel Prizes.
 Another Nobel Prize winner Robert Shiller is an authority in behavioral
finance.
The minds of the Homo Sapiens
Thinking fast and slow

 Our mind works using two different processes.

 According to Nobel Laureate Daniel Kahneman these are

system 1 and system 2.

 Richard Thaler and Cass Sunstein call them automatic and

reflective systems.
Example:

 Consider yourself crossing a busy street in India.

 Imagine the amount of calculations that a rational brain would have to do to
decide when to step off the curb.
 Think how you do this everyday…
System 1 :
 System 1 generates initial reactions which are turned into belief /conviction
if approved by system 2.

 System 1 is a treasure of information that can be accessed instantly.

 This is great for threat detection, reaction to challenges and short term
predictions.

 However it is prone to systematic errors, is not very logical or statistical.

 And it cannot be turned off!

System 1 tasks:
 Detect that one object is more distant than another.
 Orient to the source of a sudden sound.
 Detect hostility in a voice.
 Answer to 2 + 2 = ?
 Drive a car on an empty road.
 Find a strong move in chess (if you are a chess master).
 Recognize that a “meek and tidy soul with a passion for detail” resembles an occupational
stereotype.
System 2
 System 2 is reflective and deliberate.
 It takes a lot more effort and is sometimes lazy.
 It has limits based on the mental ability of individuals.
System 2 tasks
 Brace for the starter gun in a race.
 Focus attention on the clowns in the circus.
 Focus on the voice of a particular person in a crowded and noisy room.
 Look for a woman with white hair.
 Search memory to identify a surprising sound.
 Maintain a faster walking speed than is natural for you.
 Monitor the appropriateness of your behavior in a social situation.
 Count the occurrences of the letter ‘a’ in a page of text.
 Tell someone your phone number.
 Park in a narrow space (for most people except garage attendants).
 Compare two washing machines for overall value.
 Fill out a tax form.
 Check the validity of a complex logical argument.
Nature of System 2
 The video highlights that system 2 when engaged can make us
impervious to outside stimuli. It has limited resource and
allocates this preferentially.

 System 2 is also responsible for self control, following of rules,

and deliberate decisions.

 System two also produces physiological effects when engaged.

It eats up energy which can be replenished with glucose
intake!! (PNAS 2011)
A bat and ball cost $1.10.
The bat costs one dollar more than the ball.
How much does the ball cost?
Lazy system 2
 Most people answer 10 c.

 This is an instance of system 2 accepting a suggestion from system 1.

 System 2 is just too lazy.

Try to determine, as quickly as you can, if
the argument is logically valid.

Does the conclusion follow from the

premises?

All roses are flowers.

Some flowers fade quickly.
Therefore some roses fade quickly.
How does studying behavioural help?
 This helps economists determine which decisions can be
modelled as rational (using system 2) and which cannot.
 Eg: filing tax returns vs crossing a busy street.

 Allows us to correct our expectations about the system.

 Helps us design policy/strategies and incentives to counter

behavioral pitfalls in economic decisions.
The Age of Behavioural Science
 Private companies, not-for-profits, governments are increasingly using
behavioral sciences in their operations.
 UK government under David Halpern started the Behavioral Insights
Team (BIT) in 2010 - https://www.bi.team/
 USA in 2014 created White House Social and Behavioral Sciences Team
(SBST). https://sbst.gov/
 Private organizations, notably including the European Nudge Network,
are using behavioral insights creatively to promote a variety of
environmental, health-related, and other goals.
https://oecd-opsi.org/toolkits/the-european-nudging-network/
References

 Chapter 1 : Thinking Fast and Slow by Daniel Kahneman