BEHAVIORAL FINANCE

Unit I: Introduction to Behavioral Finance: Concept, Nature, Scope,

Objectives, Difference between Standard Finance and Behavioral Finance,
Traditional View of Financial Markets, Anomalies of Financial Markets,
Limitation of Efficient Market Hypothesis, Behavioral Financial Market
Strategies, Behavioral Indicators, Psychology: Social, Behavioral, Physiological
, Applied , Educational , Cognitive Psychology, Boom & Bust Cycles, Prospect
Theory, Loss aversion theory.

Unit II: Behavioral Biases theories: Heuristics, Overconfidence Bias,

Representativeness , Anchoring and Adjustment bias, cognitive dissonance bias
availability bias, self-attribution bias, illusion of control bias conservation bias,
endowment bias, optimism bias, confirmation bias, Impact of bias on investors,
External factors defining investors behavior, Fear and Greed in Financial
Market, Finance & Emotions, Investors & types, Characteristics of extremely
successful investor, Bubbles and systematic investors sentiments.

Unit III: Risk Aversion and expected marginal utility Risk aversion- Rabin
and Thaler, Expected utility theories, Rationality in investment decisions:
Concept, Limitation, assumptions for rational decision making model, Rational
decision making process, Dependency of Rationality on Time Horizon, Herbert
Simon and Bounded Rationality, Arbitrage: Limits, Types, cost involved in
arbitrage process, The model of limited Attention.

Unit IV: Geomagnetic storm Phase, types, causes, effect, Geomagnetic storm
and financial market, Impact of geomagnetic storm on stock market return,
Factors influencing stock & stock market, External factors and investors
behavior, Classification of external factors influencing investors behavior,
factors influencing on investors behaviour.

Unit V: Corporate Behavioral Finance: Introduction, Corporate decision

making: Heuristic approach, prospect theory, market variables, herding effect,
behavior of investors, and inefficiency of market, Empirical data on presence
and absence of dividend, Ex-Dividend day behavior, timing of corporate news
announcement, Behavioral life cycle.
 Unit I: Introduction to Behavioral Finance:

Concept:

Behavioural Finance is not just another branch of finance. It is the study of the
influence of psychology on the behavior of human beings in their financial
decision-making. It helps us in studying its subsequent effects on the financial
markets. It highlights the fact that human beings are not always rational, have
limits to their self-control, and are influenced by their own biases. It is the study
of how investors systematically make errors in judgement, or ―mental
mistakes‖. Behavioural finance is a relatively new field in economics and has
become an interesting topic for investment professionals.

Behavioral finance is relatively a new field which seeks to provide explanation

for people‘s economic decisions. It is a combination of behavioral and cognitive
psychological theory with conventional economics and finance. Inability to
maximize the expected utility (EU) of rational investors leads to growth of
behavioral finance within the efficient market framework. Behavioral finance is
an attempt to resolve inconsistency of Traditional Expected Utility
Maximization of rational investors within efficient markets through explanation
based on human behavior. For instance, Behavioral finance explains why and
how markets might be inefficient. An underlying assumption of behavioral
finance is that, the information structure and characteristics of market
participants systematically influence the individual‘s investment decisions as
well as market outcomes. Investor, as a human being, processes information
using shortcuts and emotional filters.

Definitions of Behavioral Finance:

Linter G.(1998) has defined behavioral finance as being study of how human
interprets and act on information to make informed investment decisions.

Olsen R. (1998) asserts that behavioral finance seeks to understand and predict
systematic financial market implications of psychological decision process.

According to Frankfurther and McGoun (2002), Behavioral finance, as a part of

behavioral economics, is that branch of finance that, with the help of theories
from other behavioral sciences, particularly psychology and sociology, tries to
discover and explain phenomena inconsistent with the paradigm of expected
utility of wealth and narrowly defined rational behavior.
 Gilovich (1999) have referred to behavioral finance as behavioral economics
and further defined behavioral economics as combining twin discipline of
psychology and economics to explain why and how people make seemingly
irrational or illogical decisions when they save, invest, spend and borrow
money.

Behavioral finance is a discipline that attempts to explain and increase

understanding regarding how the cognitive errors (mental mistakes) and
emotions of investors influence the decision making process. It integrates the
field of psychology, sociology, and other behavioral sciences to explain
individual behavior, to examine group behavior, and to predict financial
markets. According to behavioral finance people are not always rational: many
investors fail to diversify trade too much, and seem to selling winners and
holding losers. Not only that, but they deviate from rationality in predictable
ways.

Nature and Characteristics of Behavioral Finance

Four Key Themes- Heuristics, Framing, Emotions and Market Impact

characterized the Behavioral finance area.

1. Heuristics: Heuristics are referred as rule of thumb, which applies in decision

making to reduce the cognitive resources to solve a problem. These are mental
shortcuts that simplify the complex methods to make a judgment. Investor as a
decision maker confronts a set of choices within certainty and limited ability to
quantify results. This leads identification and understanding of all heuristics that
affect financial decision making. Some of heuristics are representativeness,
anchoring & adjustments, familiarity, overconfidence, regret aversion,
conservatism, mental accounting, availability, ambiguity aversion and effect.
Heuristics help to make decision.
2. 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
behavior as a ‗frame dependence‘. 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.
3. 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? Behavioral finance recognize the role
Keynes‘s ―animal spirit‖ (The term animal spirit was innovated by John
Maynard Keynes and it indicate the internal urge for action by business people
 and consumers to engage in more investment and consumption. Hence animal
spirit is the psychological urge to get into more economic activities by investors
and consumers. Keynes explains the concept in this book General Theory:
―Most, probably, of our decisions to do something positive, the full
consequences of which will be drawn out over many days to come, can only be
taken as the result of animal spirits – a spontaneous urge to action rather than
inaction.‖) plays in explaining investor choices, and thus shaping financial
markets. Underlying premises is that our feeling determine psychic reality affect
investment judgment.
4. Market Impact: Do the Cognitive errors and biases of individuals and groups
of people affect market and market prices? Indeed, main attraction of behavioral
finance field was that market prices did not appear to be fair. How market
anomalies fed an interest in the possibility that they could be explained by
psychology? Standard finance argues that investors‘ mistakes would not affect
market prices because when prices deviate from fundamental value, rational
investor would exploit the mispricing for their own profit. But who are those
who keep the market efficient? Even institutional investor exhibits the
inefficiency. And other limit to this is arbitrage. This prevents rational investor
from correcting price deviations from fundamental value. This leaves open the
possibility that correlated cognitive errors of investor could affect market prices.

Objectives:

 To introduce basic principles of behavioral finance

 To understand behavioral finance implications for investors, analysts, and
managers
 To use the behavioural finance principles for investment management
decision
 To understand psychological biases that affect financial decisions and
behavioral asset pricing.

Difference between Standard Finance and Behavioral Finance:

Areas of Standard Finance Behavioral Finance

comparison
Rationality People are rational People are not fully rational.
whenever they receive They are susceptible to
information they update cognitive and emotional
their beliefs correctly. shortcuts and errors while
making investment choices.
Wants People are guided by With utilitarian wants, they
utilitarian wants. are also guided by experience
and emotional wants.
Portfolio People select their portfolio People select their portfolio
Selection by using the mean-variance by using the behavioral
portfolio theory. portfolio theory, where
people along with returns
have social wants.
Decision making Expected utility theory Prospect theory describes
describes how people make how people make decisions
decisions under risk. under risk.
Life Cycle theory People naturally follow the People follow Behavioral life
right way to save and spend cycle theory which considers
following standard life impediments like weak
cycle theory. selfcontrol.
Asset Pricing Expected returns on The expected return from
model investments are explained investment is explained by
by the standard asset Behaviorally Asset Pricing
pricing theory like the Model.
CAPM capital asset pricing
model.
Efficient markets Markets are efficient, prices Markets are characterized by
reflect intrinsic value. It is inefficiencies and it is
not possible to beat the difficult to beat the market.
market.

Anomalies of Financial Markets:

1. Small Firms Tend to Outperform

Smaller firms (that is, smaller capitalization) tend to outperform larger
companies. As anomalies go, the small-firm effect makes sense. A company's
economic growth is ultimately the driving force behind its stock performance,
and smaller companies have much longer runways for growth than larger
companies.

A company like Microsoft (MSFT) might need to find an extra $10 billion in
sales to grow 10%, while a smaller company might need only an extra $70
million in sales for the same growth rate. Accordingly, smaller firms typically
are able to grow much faster than larger companies.
2. January Effect
The January effect is a rather well-known anomaly. Here, the idea is that stocks
that underperformed in the fourth quarter of the prior year tend to outperform
the markets in January. The reason for the January effect is so logical that it is
almost hard to call it an anomaly. Investors will often look to jettison
underperforming stocks late in the year so that they can use their losses to
offset capital gains taxes (or to take the small deduction that the IRS allows if
there is a net capital loss for the year).1 Many people call this event "tax-loss
harvesting."

As selling pressure is sometimes independent of the company's actual

fundamentals or valuation, this "tax selling" can push these stocks to levels
where they become attractive to buyers in January. Likewise, investors will
often avoid buying underperforming stocks in the fourth quarter and wait until
January to avoid getting caught up in the tax-loss selling. As a result, there is
excess selling pressure before January and excess buying pressure after January
1, leading to this effect.

3. Low Book Value

Extensive academic research has shown that stocks with below-average price-
to-book ratios tend to outperform the market. Numerous test portfolios have
shown that buying a collection of stocks with low price/book ratios will deliver
market-beating performance.

Although this anomaly makes sense to a point—unusually cheap stocks should

attract buyers' attention and revert to the mean—this is, unfortunately, a
relatively weak anomaly. Though it is true that low price-to-book stocks
outperform as a group, individual performance is idiosyncratic, and it takes
very large portfolios of low price-to-book stocks to see the benefits.

4. Neglected Stocks
A close cousin of the "small-firm anomaly," so-called neglected stocks are also
thought to outperform the broad market averages. The neglected-firm effect
occurs on stocks that are less liquid (lower trading volume) and tend to have
minimal analyst support. The idea here is that as these companies are
"discovered" by investors, the stocks will outperform.

Many investors monitor long-term purchasing indicators like P/E ratios and
RSI. These tell them if a stock has been oversold, and if it might be time to
consider loading up on shares.

Research suggests that this anomaly actually is not true—once the effects of the
difference in market capitalization are removed, there is no real
outperformance. Consequently, companies that are neglected and small tend to
outperform (because they are small), but larger neglected stocks do not appear
to perform any better than would otherwise be expected. With that said, there is
one slight benefit to this anomaly—though their performance appears to be
correlated with size, neglected stocks do appear to have lower volatility.

5. Reversals
Some evidence suggests that stocks at either end of the performance spectrum,
over periods of time (generally a year), do tend to reverse course in the
following period—yesterday's top performers become tomorrow's
underperformers, and vice versa.

Not only does statistical evidence back this up, but the anomaly also makes
sense according to investment fundamentals. If a stock is a top performer in the
market, odds are that its performance has made it expensive; likewise, the
reverse is true for underperformers. It would seem like common sense, then, to
expect that the overpriced stocks would underperform (bringing their valuation
back in line) while the underpriced stocks outperform.

Reversals also likely work in part because people expect them to work. If
enough investors habitually sell last year's winners and buy last year's losers,
that will help move the stocks in exactly the expected directions, making it
something of a self-fulfilling anomaly.

6. Days of the Week

Efficient market supporters hate the "days of the week" anomaly because it not
only appears to be true, but it also makes no sense. Research has shown that
stocks tend to move more on Fridays than Mondays and that there is a bias
toward positive market performance on Fridays. It is not a huge discrepancy,
but it is a persistent one.

On a fundamental level, there is no particular reason that this should be true.

Some psychological factors could be at work. Perhaps an end-of-week
optimism permeates the market as traders and investors look forward to the
weekend. Alternatively, perhaps the weekend gives investors a chance to catch
up on their reading, stew and fret about the market, and develop pessimism
going into Monday.

7. Dogs of the Dow

The Dogs of the Dow are included as an example of the dangers of trading
anomalies. The idea behind this theory was basically that investors could beat
the market by selecting stocks in the Dow Jones Industrial Average that had
certain value attributes.
Investors practiced different versions of the approach, but there were two
common approaches. The first is to select the 10 highest-yielding Dow stocks.
The second method is to go a step further and take the five stocks from that list
with the lowest absolute stock price and hold them for a year.

Limitation of Efficient Market Hypothesis:

Since its first implementation in the 1960s, many limitations of EMH have
gradually emerged. They are discussed in detail below –

 Market crashes and speculative bubbles

Speculative bubbles tend to arise when the price of a financial instrument rises
above its fair market value and reaches a point where market corrections take
place. During this situation, prices begin to fall rapidly, which leads to a market
crash.

But EMA suggests that both financial crashes and market bubbles should not
arise. As a matter of fact, this theory completely dismisses their existence.

 Market anomalies

Market anomalies refer to a situation where there is a difference between the

trajectory of a market price as established by the efficient market hypothesis and
its behaviour in reality. Market anomalies may arise anytime for no particular
reason. This proves that financial markets do not remain efficient at all times.

 Investors have outperformed the market

There are many investors who have consistently outperformed the market. They
do not subscribe to the suggestions of EMH and have been vocal in criticising
the same for its passive approach.

 Behavioural economics
Behavioural economics dismisses the idea that all market participants are
rational individuals. It also suggests that difficult circumstances may put stress
on individuals, forcing them to make irrational decisions. Thus, due to social
pressure, traders may also commit major errors and undertake unwarranted
risks. Also, the herding phenomenon plays a vital role in elucidating
behavioural aspects of traders which are not considered by EMH.

Behavioral Financial Market Strategies,

Behavioral Indicators :

Accountability: accepting responsibility for personal actions, results, and costs

o Make personal sacrifices to meet challenging goals, schedules, or budgets

o Express a concern for doing things better and producing quality work
o Acknowledge responsibility for failures and mistakes

Drive to Win: hustling to find and leverage opportunities to close a sale

o Maintain an aggressive cold-call schedule at all times, regardless of

frustrations
o Find opportunities to provide additional products and services to
customers
o Look across boundaries to grow the business

Technical Expertise: demonstrating up-to-date knowledge of pertinent

technical fields

o Find practical applications for new technology on the job

o Demonstrate curiosity and enthusiasm for technical aspects of the job
o Ask for and take on more challenging technical work

Psychology:

Social: -

Social psychology seeks to understand and explain social behavior. It looks at

diverse topics including group behavior, social interactions and
perceptions, leadership, nonverbal communication, and social influences on
decision-making.
Social influences on behavior are a major interest in social psychology, but
these types of psychologists are also focused on how people perceive and
interact with others. This branch of psychology also includes topics such
as conformity, aggression, and prejudice.

Behavioral –

Behavioral psychology, also known as behaviorism, is a theory of learning

based on the idea that all behaviors are acquired through conditioning.
Behavioral strategies such as classical conditioning and operant
conditioning are often utilized to teach or modify behaviors.

For example, a teacher might use a rewards system to teach students to

behave during class. When students are good, they receive gold stars,
which can then be turned in for some sort of special privilege.

While this type of psychology dominated the field during the first part of the
twentieth century, it became less prominent during the 1950s.

However, behavioral techniques remain a mainstay in therapy, education, and

many other areas.

Physiological –

If psychology is defined as the study of behavior, then physiological psychology

(also known as biological psychology) is the study of the physiological bases of
behavior. It differs from many disciplines of neuroscience, the study of the
nervous system, in its emphasis on behavior. The goal of physiological
psychology is to understand how the brain functions to control our learned and
unlearned behaviors, as well as our hopes, dreams, emotions, and cognitive
processes.

Applied –

Applied psychology is the study and ability to solve problems within human
behavior such as health issues, workplace issues, or education. There are
various specialty areas within applied psychology including clinical
psychology, counseling services, medicinal psychology, and forensic
psychology. In this article, we will cover the basics of an applied psychology
degree, the difference between basic psychology and applied psychology,
careers you can pursue with this degree and how you can major in applied
psychology.
Educational –

Educational psychology is the branch of psychology concerned with schools,

teaching psychology, educational issues, and student concerns. Educational
psychologists often study how students learn. They may also work directly with
students, parents, teachers, and administrators to improve student outcomes.

Professionals in this type of psychology sometimes study how different

variables influence individual students. They may also study learning
disabilities, giftedness, and the instructional process.

Cognitive Psychology –

Cognitive psychology is a psychological area that focuses on internal mental

states. This area has continued to grow since it emerged in the 1960s and is
centered on the science of how people think, learn, and remember.

Professionals who work in this type of psychology typically study cognitive

functions such as perception, motivation, emotion, language, learning,
memory, attention, decision-making, and problem-solving.

Boom & Bust Cycles :

The boom and bust cycle is a process of economic expansion

and contraction that occurs repeatedly. The boom and bust cycle is a key
characteristic of capitalist economies and is sometimes synonymous with
the business cycle.

During the boom the economy grows, jobs are plentiful and the market brings
high returns to investors. In the subsequent bust the economy shrinks, people
lose their jobs and investors lose money. Boom-bust cycles last for varying
lengths of time; they also vary in severity.

 The boom and bust cycle describes alternating phases of economic

growth and decline typically found in modern capitalist economies.
 First anticipated by Karl Marx in the 19th century, the boom bust cycle is
driven just as much by investor and consumer psychology as it is by
market and economic fundamentals.
 The cycle can last anywhere from several months to several years, with
the average length being approximately 5 years going back to the 1850s.
Prospect Theory:

Prospect theory assumes that losses and gains are valued differently, and thus
individuals make decisions based on perceived gains instead of perceived
losses. Also known as the "loss-aversion" theory, the general concept is that if
two choices are put before an individual, both equal, with one presented in
terms of potential gains and the other in terms of possible losses, the former
option will be chosen.

 The prospect theory says that investors value gains and losses
differently, placing more weight on perceived gains versus perceived
losses.
 An investor presented with a choice, both equal, will choose the one
presented in terms of potential gains.
 Prospect theory is also known as the loss-aversion theory.
 The prospect theory is part of behavioral economics, suggesting
investors chose perceived gains because losses cause a greater emotional
impact.
 The certainty effect says individuals prefer certain outcomes over
probable ones, while the isolation effect says individuals cancel out
similar information when making a decision.

Prospect theory belongs to the behavioral economic subgroup, describing how

individuals make a choice between probabilistic alternatives where risk is
involved and the probability of different outcomes is unknown. This theory was
formulated in 1979 and further developed in 1992 by Amos Tversky and
Daniel Kahneman, deeming it more psychologically accurate of how decisions
are made when compared to the expected utility theory.

The underlying explanation for an individual‘s behavior, under prospect theory,

is that because the choices are independent and singular, the probability of a
gain or a loss is reasonably assumed as being 50/50 instead of the probability
that is actually presented. Essentially, the probability of a gain is generally
perceived as greater.

Loss aversion theory:

Loss aversion in behavioral economics refers to a phenomenon where a real or

potential loss is perceived by individuals as psychologically or emotionally
more severe than an equivalent gain. For instance, the pain of losing $100 is
often far greater than the joy gained in finding the same amount.

The psychological effects of experiencing a loss or even facing the possibility

of a loss might even induce risk-taking behavior that could make realized
losses even more likely or more severe.

 Loss aversion is the observation that human beings experience losses

asymmetrically more severely than equivalent gains.
 This overwhelming fear of loss can cause investors to behave irrationally
and make bad decisions, such as holding onto a stock for too long or too
little time.
 Investors can avoid psychological traps by adopting a strategic
asset allocation strategy, thinking rationally, and not letting emotion get
the better of them.
Nobody likes to lose, especially when it could result in losing money. The fear
of realizing a loss can cripple an investor, prompting them to hold onto a losing
investment long after it should have been sold or to offload winning stocks too
soon—a cognitive bias known as the disposition effect. Rookies often make the
mistake of hoping a stock will bounce back, against all evidence to the
contrary, because losses lead to more extreme emotional responses than gains.

Behavioral economists claim that humans are wired for loss aversion, one of
many cognitive biases identified by. Some psychological studies suggest that
the pain of losing is psychologically about twice as powerful as the joy we
experience when winning. However, several studies also call into question the
practical effect or even the existence of loss aversion. Nonetheless, it may be
possible that overwhelming fear can cause investors to behave irrationally and
make poor investment decisions.
 Unit II: Behavioral Biases theories:

Heuristics :

Heuristics refers to a problem-solving and decision-making approach where

individuals or entities consider past results or experiences and the minimal
relevant details to reach a practical conclusion. These strategies utilize mental
shortcuts and generalized concepts to find immediate, efficient, and short-term
solutions.

A heuristic model acts as a rule of thumb in cases where there is no time for
careful consideration of different aspects of a situation. Though this technique
does not always give accurate, rational, or optimal results, it satisfies the
requirements awaiting valid conclusions or decisions in complex scenarios. Its
purpose is to solve a problem or achieve an outcome quickly with minimal
mental effort and without analyzing everything thoroughly.

Herbert A. Simon, a Nobel Laureate and American economist, proposed the

concept in the 1950s. He claimed that humans try to make rational decisions but
are ultimately impacted by cognitive heuristics. However, the technique gained
traction following Israeli psychologist Daniel Kahneman‘s book ―Thinking,
Fast and Slow.‖ He hypothesized that these biases have an impact on how
people think and make decisions.

Heuristics may be the most effective method for resolving problems, whether
they are personal or professional. These short-term results provide ample time
to make decisions that will solve difficulties permanently. The strategy has been
found effective, if not accurate, as a short-term technique of dealing with
problems or making correct decisions. Nevertheless, it has also been regarded as
a method of reducing effort.

Types of Heuristics Methods

Here are the various sorts of heuristics based on the sources, contexts, and
problems from which one derives the solutions or decisions:

1.Affect

It emphasizes the instant emotions generated in individuals in response to a

stimulus. It could be any positive or negative feeling they experience at a
particular moment and in a specific situation. In short, this strategy signifies
how the emotions or reactionary feelings triggered by previous experiences can
influence a decision. This emotionally-driven approach, sometimes known as
gut feeling, is common in situations that require evaluating the benefits and
risks of something in a short time.

For example, when readers come across an article that promotes a product or
service, clicking affiliate links will redirect them to the store‘s website. There
may be people who either want to buy something or look at the offerings. On
the other hand, some visitors may read the article in the hopes of learning
something new, but they quickly abandon the site if it appears to be
promotional.
2.Anchoring

In this approach, individuals or entities make judgments based on the very first
set of information they get called ―anchor‖. Since the decision is usually made
in a hurry, it may be inaccurate. The impulsive decision-makers forget or ignore
other factors, making not-so-good choices.

For example, an instant message about winning the latest automobile in

exchange for a particular sum of money seems intriguing. People, however, pay
just to be stuck in a deceptive bargain out of sheer excitement.

3.Availability

It is a process in which persons or entities recall previous related instances and

evaluate their effectiveness in resolving problems. It is due to the most
significant sources to refer to for reaching valid conclusions are the readily
available ones. However, they are more likely to make poor decisions or come
up with incorrect solutions to issues because of this process.

For example, someone wants to invest in cryptocurrencies but is unsure which

one to buy. So, they can look into the historical performance of the most
popular digital coins on the market. Following that, they can make investment
decisions depending on which has been the most successful.

4.Representativeness

This technique makes individuals or entities evaluate the likelihood of a

solution to a problem or conclusion in a situation based on a similar past event
that acts as representative data. It, thus, provides a reasonable probability of
selecting the most effective alternative under uncertainty.

For example, a company is going through a financial crisis. So it can review

how other organizations in comparable situations have recovered. It will aid in
determining which methods or techniques to employ to achieve effective
results.

Overconfidence Bias :

The overconfidence bias is the tendency people have to be more confident in

their own abilities, such as driving, teaching, or spelling, than is objectively
reasonable. This overconfidence also involves matters of character.
Generally, people believe that they are more ethical than their competitors, co-
workers, and peers. For example, a recent study showed that 50% of business
people polled believed that they were in the top 10% ethically.

Because of the overconfidence bias, people will often take ethical issues lightly.
They simply assume that they have good character and will therefore do the
right thing when they encounter ethical challenges. In fact, studies show that the
overconfidence bias causes people to overestimate how much, and how often,
they will donate money or volunteer their time to charities.

So, overconfidence in our own moral character can cause us to act without
proper reflection. And that is when we are most likely to act unethically.

Representativeness :

The representativeness heuristic is a type of cognitive bias or mental shortcut.

Just like other types of heuristics, such as the availability
heuristic and anchoring bias, it can help us reduce the time and effort needed
to make reasonably good judgments. At the same time, it can lead us astray
because we only pay attention to a subset of information: in this case, similarity.

Under the representativeness heuristic, we estimate the probability of something

belonging to a specific category based on the degree to which it resembles (or is
representative of) the typical or average member of the category. This is called
a prototype.

Anchoring and Adjustment bias:

Anchoring and adjustment refer to the cognitive bias whereby a person is

heavily dependent on the information received initially (referred to as the
―anchor‖) while making subsequent decisions. In other words, all the following
choices are influenced and require adjustments to remain close to the initial
anchor value, which can cause a problem if the anchor is too different from the
true value. Typically, this bias is seen when individuals build future outcomes
based on available information.

A person exhibits anchoring and adjustment behavior during decision-making

when the initial set of information heavily influences all their decisions.
Typically, the individual would tend to integrate all those ideas that fall within
the acceptable range of the anchor and reject those that are not in line with the
anchor. So, only those values are discussed close to the anchor in all genuine
arguments, negotiations, estimates, etc. The underlying principle of anchoring
and adjustment is that an individual chooses a particular value or number as the
starting point (a.k.a. the anchor), eventually becoming the target number.
Subsequently, the individual adjusts the following information until it reaches
within an acceptable range of the target value over the period.

Cognitive dissonance bias

The term cognitive dissonance is made up of two words, i.e., cognitive, which
means relating to the brain, and dissonance, which means turmoil or discomfort.
Hence, cognitive dissonance bias is related to the mental discomfort which
investors have to go through if they have to hold two conflicting views about
the market in their minds.

An example of cognitive dissonance bias is when an investor purchases the

stock believing that it will give a 15% per annum return. However, over a
period of three years, that does not happen. Instead, other stocks provide the
15% per annum return. In this situation, investors face mental discomfort. On
the one hand, he/she may believe in the stock that they initially purchased in
whereas, on the other hand, he/she may want to liquidate the stock and buy the
other one in order to achieve their immediate investment goals. Investors often
go to great lengths to convince themselves that their initial decision was right.
They do so because they are predisposed to maintaining their old beliefs. A lot
of times, the cognitive dissonance becomes difficult to manage, and hence
investors take hasty decisions. These decisions may not be rational or even in
their best interest. They are simply taken to achieve cognitive stability.

Availability bias :

Availability bias refers to the tendency of investors to extrapolate their

personal trends and consider them to be the market reality. For instance, the
business of a certain person may be profitable even during a recession. Hence,
they are likely to assume that even if the recession continues, the market will
continue to rise further. On the other hand, if a person has suffered a job loss in
a growing economy, he/she is likely to believe that the entire economy is
headed downwards.

Availability bias is called the availability bias because it depends upon the user
being able to recall their experiences. The experiences which are most vivid or
deeply experienced are the ones most readily available for decision making.
This is the reason that this bias is called the ―availability bias.‖

Availability bias is the reason that an investor who may have lost money in the
share markets starts to believe that the markets are excessively risky and hence
avoids investing in them. Availability bias basically explains how the beliefs of
an investor can become excessively influenced by their experiences and hence
can go completely out of sync with reality.

Types of Incidents Which Impact Availability Bias?

All incidents do not impact availability bias in a similar manner. Over the years,
psychologists have studied and realized that there are some types of incidents
that are more likely to be recalled. Some characteristics of such incidents are as
follows:

 Incidents which happen more frequently are more likely to be recalled

 Incidents which are unusual or extreme in some way are more likely to be
recalled
 Negative incidents are recalled more easily than positive incidents (loss
aversion)
 Recent incidents are recalled more easily than incidents which have
happened in the past

Self-attribution bias :

Behavioural finance is one of the growing fields in finance and heuristic or

bias is one of the part of it. In this article, we would be understanding the
impact of self-attribution bias on investors.

While investing, various things affect the outcome of investments and heuristics
or biases is one such thing. According to the studies of behavioural finance,
there are a lot of biases that investors carry while investing. In this article, we
would be dealing with one such bias called self-attribution bias, the outcome of
which might lead to devasting results.

In terms of investing, self-attribution bias is a tendency where investors accredit

success to their own actions and abilities while refusing to accept the poor
investing outcome as their fault.

This does make a difference since investors are less likely to learn from their
mistakes and would never acknowledge that they need to be well informed.
Let‘s say an investor invests in an IT company, but soon after he invests the
stock prices of the IT company start falling. So, in this scenario investors rather
than blaming the CEO of that company for mismanaging the business or even
the market itself for heading downwards, they would blame the friend who told
him about the company.

Now let‘s look at another scenario. Let‘s say this time the investor invests in a
banking stock and he gets successful as the stock price of that bank starts rising
as soon as he invests. Now to whom would the investor accredit these gains?
So, here he attributes to himself. In this scenario, the investor believes that they
already knew that the company would prove to be a good investment.

Carrying a self-attribution bias does have a negative impact in the long run as it
can certainly lead to unfavourable outcomes. Therefore, while you invest
become as objective as possible.

Illusion of control bias

Illusion of control bias is the tendency of investors to believe that they have a
certain degree of control over the outcomes of investment markets! Not all
investors believe that they have complete control. However, a lot of them do
believe that they have some influence over the market. In most cases, this is not
true because investment markets are huge markets where trillions of dollars
change hands every week. Hence, if an individual investor or even a small to
mid-size institution believes that they are in control of the market, they may be
wrong.

It is true that some of the investor‘s predictions might come true in the short
run. However, it may be a mere co-incidence and may not prove anything in the
long run. A lot of times, investors feel in control of thier portfolios because they
use techniques such as limit orders, etc., to buy and sell shares. However, in
many cases, it just leads to unnecessary buying and selling as prices fluctuate
within a given range. The illusion of control bias is also closely linked to the
feeling of overconfidence, which has been discussed in another article.

Conservation bias:

In accounting, conservatism means that if two values of an asset are present, the
accountant recognizes the lower value. Hence, the principle of conservatism is
based on how an investor is supposed to react when they receive multiple and
often contradictory reports about the same asset.
This is the case in behavioral finance as well. However, it has been observed
that investors often form a deeply emotional view about an investment. This
view may be positive or negative. However, it is developed earlier. Then, when
the same investor is presented with information that is contradictory to their
view formed earlier, they simply discount the new information and hang on to
their original opinion. Sometimes, investors may not react to new information,
and other times, they may react very slowly.

For example, investors may have a belief that a company like Enron is a good
investment. Hence, when early information about the possibility of a scam in
Enron came to light, a lot of these investors stuck to their previous views and
were slow to react. In the process, the details of the scam became public, and
some investors lost a huge portion of their investment.

The Root Cause of Conservatism Bias

As investors, we are aware that conservatism bias does actually exist in the
marketplace. We have experienced it ourselves, or we may have come across
others who have experienced it over time. However, we don‘t much about the
root causes because of which conservatism bias continues to exist.

 Failure to Revaluate Complex Data: The first and foremost reason is

that formulating an opinion on the financial position of a company is a
complex task. The investor has to go through a wide range of financial
information and critically analyze the same before they can make any
decisions. This process is both arduous as well as time-consuming. The
problem is that whenever new information about the company comes out,
the investor is supposed to perform the entire analysis again. This can be
physically as well as emotionally stressful for the investor. Hence, instead
of forming new opinions, the buyers simply hold on to pre-existing beliefs
about the firm.
 Cling to Forecasts: Investors have an innate need to feel validated. When
investors go through results, very few of them are objectively viewing the
results. Instead, they are validating their own beliefs. Hence, if an earlier
forecast provided by the company or critics matches with their beliefs,
they tend to hang on to that belief instead of reformulating their beliefs. If
an investor reads a hundred-page report, they are more likely to remember
the four or five pages that validate their belief.
 Slow to React: The initial belief of the investor is firmly entrenched in
their mind. Hence, they do not change that belief unless there is
overwhelming evidence that their initial belief is wrong. They often take a
long time processing the information in their heads. As a result, they are
 often slow to react. This may cause them to hold on to stocks longer than
they should cause erosion in their wealth.

Endowment bias:

The endowment effect is a cognitive bias that skews the investor‘s perception of
the valuation of an object depending upon whether they own it or not. Let us
understand this with the help of an example. In one of the studies related to the
endowment effect, people were given the same coffee mug and were asked to
decide its value. There were two sets of people, one had to value the coffee mug
as the buyer, whereas the other had to value the coffee mug as the seller. At the
end of the study, it was found that the average price of the group of sellers was
close to $7, whereas the average price of the group of buyers for the same object
was close to $3! This was a huge variation considering the fact that the
underlying object was the same.

In behavioral finance, this phenomenon is called the endowment effect. This

means that when a person owns stock or an investment, they often become
emotionally engaged with the object. This is the reason that they place an
excessively higher value on the stock. As a result, their worldview of the market
becomes skewed and biased. Since they are not able to value the stocks
objectively, they are not able to devise trading strategies objectively either.

How the Endowment Effect Affects Investment Decisions?

The endowment effect impacts the investment decision in a wide variety of
ways. Some of these impacts have been listed below:

 Overvaluation of the Portfolio: Most investors tend to have an emotional

connection with their own portfolio. This is the reason that they tend to
value the stocks and ETFs in their own portfolio at a higher rate. This
causes most investors to effectively price their securities and sell them.
They set target selling prices in their mind. However, once the target is hit,
they keep on setting higher targets. This is because they feel that their own
stock is such a great pick and that they would not want to lose out on such
a great investment by selling out early.
 Holding on to a Mediocre Stock: If an investor purchases a stock that
gives a great performance, in the beginning, it is likely that the investor
will keep on holding the stock for a very long time. This is because the
investor has become emotionally attached to a stock and hence views it as
a winner. Hence, even if it gives a mediocre performance in the
 subsequent years, the investor will keep holding on to it. For example, if a
stock provides a 25% return in the first two years and then a 5% return in
the next ten years, investors would continue holding the stock for a very
long time.
 The “Hold” Recommendation: Research analysts have an entire category
of ―hold‖ recommendations just to satisfy the endowment effect.
Generally, there should be only two categories, i.e., buy and sell. If the
current price is a good bargain and you are holding on to the stock today,
you are effectively buying the stock. In a way, not selling can be
considered to be buying in a highly liquid market. However, research
analysts know that there are many investors who wouldn‘t buy the stock at
the current price. However, if they already have the stock, they will
perceive it to be more valuable and hence wouldn‘t sell it either. This is
the reason that they have created an entire recommendation called ―hold‖
because they know of the existence of the endowment effect.
How Can Investors Manage the Endowment Effect?
Now, since we know that the endowment effect can wreak havoc on a portfolio,
it is important to learn how to manage it.

 Consider Opportunity Costs: The best way to avoid the endowment

effect is to understand that it exists. This can be done by asking oneself the
opportunity cost. If the benefits to be derived from the next best
opportunity are considerably higher than the benefits from the current
stock, then it must be sold, and the money must be reinvested to maximize
the gains. If you look at a 5% gain in isolation, you are likely to fall prey
to the endowment effect. However, if you consider the 5% gain in front of
an 8% gain, you will be able to see the bias and avoid it.
 Psychological Ownership: Finally, it is important to view the stocks and
investments as a means to an end. It is important that people do not get
unnecessarily emotionally attached to their investments.

Optimism bias:

Optimism bias can be explained better by looking at the investors' core beliefs.
Investors with optimism bias are aware that bad things can and do happen in the
investment market. However, they are often of the opinion that these bad things
cannot really happen to them. They implicitly believe that such bad things can
only happen to others.
It is easy to see why this kind of thinking can be dangerous. If an investor truly
believes that bad things cannot and will not happen to them, then they stop
taking precautions. Since they disassociate themselves from the results of their
actions, they often start making reckless decisions.

Investors who are afflicted with optimism bias often have an internal view of
the markets. This means that they view the markets from their current financial
and emotional situation. This is opposed to what the actual situation in the
market is. A rational investor would make unbiased decisions based on market
realities. However, optimism bias inhibits the ability of the investors to do so. It
is important to realize the fact that such investors have optimism inbuilt in them.
They are generally not unduly influenced by external situations. The reality is
that they already had a certain feeling and that the rosy forecasts just confirm
what they always believed to be true. It has been observed that even if such
investors are presented with data that contradicts their views, they are simply
likely to ignore it.

Confirmation bias:

Confirmation bias is the tendency of human beings to actively search for

information that matches with the preconceived notion that they have.
Individuals tend to pay an excessively large amount of attention to the
information which confirms their beliefs. At the same time, they tend to
discredit any information that does not conform to their belief.

It needs to be understood that the investor is not doing any of this consciously.
Instead, the entire process takes place subconsciously. Investors tend to hold a
belief which is often not the result of due diligence. The mind of the investor
automatically seeks out information that helps confirm the belief while
shunning away information that contradicts it. The problem with confirmation
bias is that the investor feels as though they have done the required due
diligence even though they really haven‘t

How Confirmation Bias Affects Investment Behaviour?

Confirmation bias affects decisions in all walks of life. However, it has a
profound effect when it comes to financial behavior. Some of the main
distortions caused by confirmation bias have been listed below:

 Missed Opportunities: Confirmation bias is responsible for a large

amount of missed opportunities. This is because investors are only able to
identify an opportunity and invest in it if they are able to get a fair and
unbiased view. However, investors who have a confirmation bias are
 actually preoccupied with their own thought processes. They do not tend
to pay attention to the opportunities presented to them. This is because
they are preoccupied with their own notions.
 Concentrated Portfolios: Probably, the worst outcome of confirmation
bias is a concentrated portfolio. It is a known fact that over the course of
time, diversification provides a shield to investors. Investors who have a
diversified portfolio earn a better risk-adjusted return as compared to their
peers. Confirmation bias causes the thinking of the investors to become
distorted. They become obsessed with a few companies or a few
investment classes. This causes them to ignore diversification and
concentrate their holdings in a single company or investment class. This
may benefit them in the short run. However, empirical evidence states that
in the long run, diversified portfolios do much better than concentrated
portfolios.
 Prone to Bubbles: Another problem with confirmation bias is that this
thinking is prone to get the investors into asset bubbles. This is because, in
the case of asset bubbles, the price of the asset keeps on going higher until
one fine day, it doesn‘t anymore. This means that people with
confirmation bias are likely to invest more and more in asset bubbles as
compared to other investors.

Impact of bias on investors:

 Representative bias may lead to snap judgments because of a situation's

similarities to an earlier matter.
 Cognitive dissonance leads to an avoidance of uncomfortable facts that
contradict one's convictions.
 Home country bias and familiarity bias lead to an avoidance of anything
outside one's comfort zone.
 Confirmation bias describes how people naturally favor information that
confirms their previously existing beliefs.
 Mood bias, optimism (or pessimism) bias, and overconfidence bias all
add a note of irrationality and emotion to the decision-making process.
 The endowment effect causes people to over-value the things they own
just because they own them.
 Status quo bias is resistance to change.
 Reference point bias and anchoring bias are tendencies to value a thing
in comparison to another thing rather than independently.
 The law of small numbers is the reliance on a too-small sample size to
make a decision.
  Mental accounting is an irrational attitude towards spending and valuing
money.

External factors defining investors behaviour :

1. Interest rates (the cost of borrowing)

Investment is financed either out of current savings or by borrowing. Therefore
investment is strongly influenced by interest rates. High interest rates make it
more expensive to borrow. High interest rates also give a better rate of return
from keeping money in the bank. With higher interest rates, investment has a
higher opportunity cost because you lose out the interest payments.

The marginal efficiency of capital states that for investment to be worthwhile, it

needs to give a higher rate of return than the interest rate. If interest rates are
5%, an investment project needs to give a rate of return of at least 5% or more.
As interest rates rise, fewer investment projects will be profitable. If interest
rates are cut, then more investment projects will be worthwhile.
 2. Economic growth (changes in demand)
Firms invest to meet future demand. If demand is falling, then firms will cut
back on investment. If economic prospects improve, then firms will increase
investment as they expect future demand to rise. There is strong empirical
evidence that investment is cyclical. In a recession, investment falls, and
recover with economic growth.

3. Confidence/expectations
Investment is riskier than saving. Firms will only invest if they are confident
about future costs, demand and economic prospects. Keynes referred to the
‗animal spirits‘ of businessmen as a key determinant of investment. Keynes
noted that confidence wasn‘t always rational. Confidence will be affected by
economic growth and interest rates, but also the general economic and political
climate. If there is uncertainty (e.g. political turmoil) then firms may cut back
on investment decisions as they wait to see how event unfold.

4. Technological developments (productivity of capital)

In the long-term, inflation rates can have an influence on investment. High and
variable inflation tends to create more uncertainty and confusion, with
uncertainties over the future cost of investment. If inflation is high and volatile,
firms will be uncertain at the final cost of the investment, they may also fear
high inflation could lead to economic uncertainty and future downturn.
Countries with a prolonged period of low and stable inflation have often
experienced higher rates of investment.

5. Availability of finance from banks.

Long-term changes in technology can influence the attractiveness of investment.
In the late nineteenth century, new technology such as Bessemer steel and
improved steam engines meant firms had a strong incentive to invest in this new
technology because it was much more efficient than previous technology. If
there is a slowdown in the rate of technological progress, firms will cut back
investment as there are lower returns on the investment.

6. Others (depreciation, wage costs, inflation, government policy)

In the credit crunch of 2008, many banks were short of liquidity so had to cut
back lending. Banks were very reluctant to lend to firms for investment.
Therefore despite record low-interest rates, firms were unable to borrow for
investment – despite firms wishing to do that.

Another factor that can influence investment in the long-term is the level of
savings. A high level of savings enables more resources to be used for
investment. With high deposits – banks are able to lend more out. If the level of
savings in the economy falls, then it limits the amounts of funds that can be
channelled into investment.

Wage costs
If wage costs are rising rapidly, it may create an incentive for a firm to try and
boost labour productivity, through investing in capital stock. In a period of low
wage growth, firms may be more inclined to use more labour-intensive
production methods.

Depreciation
Not all investment is driven by the economic cycle. Some investment is
necessary to replace worn out or outdated equipment. Also, investment may be
required for the standard growth of a firm. In a recession, investment will fall
sharply, but not completely – firms may continue with projects already started,
and after a time, they may have to invest in less ambitious projects. Also, even
in recessions, some firms may wish to invest or startup.

Government policies
Some government regulations can make investment more difficult. For
example, strict planning legislation can discourage investment. On the other
hand, government subsidies/tax breaks can encourage investment. In China and
Korea, the government has often implicitly guaranteed – supported the cost of
investment. This has led to greater investment – though it can also affect the
quality of investment as there is less incentive to make sure the investment has a
strong rate of return.

Fear and Greed in Financial Market:

There is an old saying on Wall Street that the market is driven by just two
emotions: fear and greed. Although this is an oversimplification, it can often
ring true. Succumbing to these emotions, however, can also profoundly harm
investor portfolios, the stock market's stability, and even the economy on the
whole. There is a vast academic literature, known as behavioral finance, which
is devoted to the topic of understanding market psychology.

 Letting emotions govern investment behavior often leads to irrational

decision-making that can cost you dearly.
 It's usually best to ignore the trend at the moment—whether bullish or
bearish—and stick to a long-term plan based on sound fundamentals.
 It's also critical to understand how risk-sensitive you are and to set your
asset allocations accordingly when fear and greed grip the market.
Most people want to get rich as quickly as possible, and bull markets invite us
to try it. The internet boom of the late 1990s is a perfect example. At the time,
it seemed all an adviser had to do was pitch any investment with "dotcom" at
the end of it, and investors leaped at the opportunity. Accumulation of internet-
related stocks, many of them barely startups, reached a fever pitch. Investors
got exceedingly greedy, fueling ever more buying and bidding prices up to
excessive levels. Like many other asset bubbles in history, it eventually burst,
depressing stock prices from 2000 to 2002.

Just as the market can become overwhelmed with greed, it can also succumb to
fear. When stocks suffer large losses for a sustained period, investors can
collectively become fearful of further losses, so they start to sell. This, of
course, has the self-fulfilling effect of ensuring that prices fall further.
Economists have a name for what happens when investors buy or sell just
because everyone else is doing it: herd behavior.

Finance & Emotions:

Investors & types:

1. Angel Investors
Angel investors are individuals. These investors have an earned income that
exceeds $200,000 annually or have a net worth that exceeds $1 million. They
can be found across industry sectors, but usually work with entrepreneurs who
are somewhere between their first-time financing and a venture capital effort.

2. Peer-to-Peer Lenders
Peer-to-peer lenders can be individuals or groups. They help fund small
businesses. If you want to apply for peer-to-peer lending, you need to apply
with companies who are specialized in this type of financing. Lenders work
with these companies to find businesses they want to finance.

3. Personal Investors
Businesses can turn to their family, friends, and networks for their first
investments. Talk to an expert if you have people eager to help; only a certain
amount of people can invest in startups and you‘ll need to provide thorough
documentation.
4. Banks
Banks are a classic source for business loans. Before your application is
approved, you will need to produce proof of a revenue stream or collateral.
Because of this, banks are usually a better option for established businesses, but
you don‘t need to be a mogul to get financing.

5. Venture Capitalists
Venture capitalists are private equity investors that provide capital to companies
exhibiting high growth potential in exchange for an equity stake. They usually
invest sizable amounts of money and are typically used once a business
demonstrates the potential for significant revenue.

Characteristics of extremely successful investor:

1. Reason:
Arguably the most important characteristic. You need to justify why you hold
each company in your portfolio. You must seek out high-quality stocks that are
undervalued by the market, and therefore cheap.

2. Commitment:
To exploit your strategy you have to do the research – and keep doing it –
including surveying all financial data, online investment resources and company
reports. Don‘t forget that ―numbers have no prejudices.‖

3. Discipline:
The research process doesn‘t finish once you‘ve bought a stock.You have to
obsessively follow your purchases, to make sure they were sensible.
You‘ll need discipline, because successful investing is about running your
profits and cutting your losses. The stockmarket is a rollercoaster, so you have
to ride out the peaks and bottoms.

4. Flexibility:
If you‘re going to have rules you need to be able to break them!‖ The same
stocks won‘t perform well in all markets.

5. Guts:
The best time to buy stocks is the time of ―maximum pessimism‖ – when
everyone is selling and fleeing the markets. To do this takes bravery.

6. Open Mind:
Seeking out opportunities ignored by other investors prevents prejudices
coming between you and an opportunity.

7. Patience:
―Unfashionable stocks‖ are unlikely to turn around overnight, so you need to
know when to hold on.

8. Know Your Limits:

This means accepting you won‘t be the next Warren Buffett. Professional
investors spend their whole day researching companies, have analysts to help
them, and can visit companies.
 Unit III: Risk Aversion and expected marginal utility Risk aversion

Rabin and Thaler,

Expected utility theories:

This is a theory which estimates the likely utility of an action – when there is
uncertainty about the outcome. It suggests the rational choice is to choose an
action with the highest expected utility.

This theory notes that the utility of a money is not necessarily the same as the
total value of money. This explains why people may take out insurance. The
expected value from paying for insurance would be to lose out monetarily. But,
the possibility of large-scale losses could lead to a serious decline in utility
because of the diminishing marginal utility of wealth.

Expected value
Expected value is the probability-weighted average of a mathematical outcome.

For example, suppose:

 A lottery ticket costs $20.

 The probability of winning the $2000 prize is 0.5%
 The likely value from having a lottery ticket will be the
outcome x probability of the event occurring.
 Therefore, expected value = 0.005 x 2000 = $10
The expected value of owning a lottery ticket is $10. With an infinite number of
events, on average, this is the likely payout. Of course, we may be lucky or
maybe unlucky if we play only once.

Since the ticket costs $20, it seems an illogical decision to buy – because the
expected value of buying a ticket is $10 – a smaller figure than the cost of
purchase $20.

Expected utility theory is a model that represents preference over risky objects,
by weighted average of utility assigned to each possible outcome, where the
weights are the probability of each outcome.

The primary motivation for introducing expected utility, instead of taking the
expected value of outcomes, is to explain attitudes toward risk. Consider for
example a lottery, which gives $100 and $0 with even chances, and a sure
receipt of $50. Here typically one chooses the sure receipt, whereas the two
alternatives yield the same expected return. Another example is the Saint
Petersburg paradox. Consider a game of flipping a fair coin until one has a tail.
When the number of flips obtained is k, one receives 2 k, which happens with
probability (1/2)k. The expected return of this game is , which is infinity.
However, a typical decision maker is willing to pay only a finite amount for
playing this game.

Rationality in investment decisions:

Concept:

When evaluating the profit potential and risk of an investment, a rational human
being would consider objective measures, such as the expected return, the
standard deviation or the beta factor measuring the correlation of a firms return
with the market return. However, according to behavioral finance, humans do
not act rational when making investment decision. Instead they are often
influenced by emotions and biases that take the focus away from objective
decision criteria and lead to irrational decision making (Weber, Borgsen,
Glaser, & Norden, 2015).

According to Weber, there are two factors that influence how human beings
make investment decisions:

1. Individual perception of investment risk,

2. Personal attitude towards risk.

Although every investment has an objective risk, the individual perception of

risk varies from one person to another. Outside factors such as the presentation
format, timing, personal experience or cultural influences affect how the risk of
an investment is subjectively perceived by a person. Once the subjective risk
perception is determined, the personal attitude towards risk determines the
final investment decision. The higher the personal level of risk aversion, the
more negative that person‘s decision making is affected by one unit of
perceived risk. As a consequence, the person is less likely to make investment
decisions that carry high levels of perceived risk.

These personal biases within people are different from one person to another
and lead to irrational decision making. For example, an investor who has
repeatedly gotten high returns on his investments during a period of economic
growth might falsely attribute this success to his own knowledge and skills as
an investor and develop an overconfidence. As a result, he is likely to
underestimate the objective risk of investments in the future and make
suboptimal decisions.
 Weber argues that in order to make optimal investment decisions it is essential
to stay rational and to not let emotions and biases influence your actions.
Therefore, I will use the following section to discuss some strategies that may
be used to reduce the influence of biases.

Limitation:

 People rarely have full (or perfect) information. For example, the information
might not be available, the person might not be able to access it, or it might take
too much time or too many resources to acquire. More complex models rely on
probability in order to describe outcomes rather than the assumption that a
person will always know all outcomes.
 Individual rationality is limited by their ability to conduct analysis and think
through competing alternatives. The more complex a decision, the greater the
limits are to making completely rational choices.
 Rather than always seeking to optimize benefits while minimizing costs, people
are often willing to choose an acceptable option rather than the optimal one.
This is especially true when it is difficult to precisely measure and
assess factors among the selection criteria.

Assumptions for rational decision making model:

 Problem Clarity-
o The problem is clear and unambiguous.

 Known Options-
o The decision-maker can identify all relevant criteria and viable
alternatives.

 Clear Preferences-
o Rationality assumes that the criteria and alternatives can be ranked
and weighted.

 Constant Preferences-
o Specific decision criteria are constant and that the weights assigned
to them are stable over time.

 No Time or Cost Constraints-

o Full information is available because there are no time or cost
constraints.
  Maximum Payoff-
o The choice alternative will yield the highest perceived value.

Rational decision making process:

1. Verify and define your problem.

To prove that you actually have a problem, you need evidence for it. Most
marketers think data is the silver bullet that can diagnose any issue in our
strategy, but you actually need to extract insights from your data to prove
anything. If you don‘t, you‘re just looking at a bunch of numbers packed into a
spreadsheet.
Example:
―After analyzing our blog traffic report, we now know why our traffic has
plateaued for the past year -- our organic traffic increases slightly month over
month but our email and social traffic decrease.‖
2. Research and brainstorm possible solutions for your problem.
Expanding your pool of potential solutions boosts your chances of solving your
problem. To find as many potential solutions as possible, you should gather
plenty of information about your problem from your own knowledge and the
internet. You can also brainstorm with others to uncover more possible
solutions.

Example:
Potential Solution 1: ―We could focus on growing organic, email, and social
traffic all at the same time."
Potential Solution 2: ―We could focus on growing email and social traffic at the
same time -- organic traffic already increases month over month while traffic
from email and social decrease.‖

3. Set standards of success and failure for your potential solutions.

Setting a threshold to measure your solutions' success and failure lets you
determine which ones can actually solve your problem. Your standard of
success shouldn‘t be too high, though. You‘d never be able to find a solution.
But if your standards are realistic, quantifiable, and focused, you‘ll be able to
find one.

Example:
―If one of our solutions increases our total traffic by 10%, we should consider it
a practical way to overcome our traffic plateau.‖

4. Flesh out the potential results of each solution.

Next, you should determine each of your solutions‘ consequences. To do so,

create a strength and weaknesses table for each alternative and compare them to
each other. You should also prioritize your solutions in a list from best chance
to solve the problem to worst chance.

Example:
Potential Result 1: ‗Growing organic, email, and social traffic at the same time
could pay a lot of dividends, but our team doesn‘t have enough time or
resources to optimize all three channels.‖

5. Choose the best solution and test it.

Based on the evaluation of your potential solutions, choose the best one and test
it. You can start monitoring your preliminary results during this stage too.

Example:
―Focusing on organic traffic seems to be the most effective and realistic play for
us. Let‘s test an organic-only strategy where we only create new content that
has current or potential search volume and fits into our pillar cluster model.‖
6. Track and analyze the results of your test.
Track and analyze your results to see if your solution actually solved your
problem.

Example:
―After a month of testing, our blog traffic has increased by 14% and our organic
traffic has increased by 21%.‖

7. If the test solves your problem, implement the solution. If not, test a new one.
If your potential solution passed your test and solved your problem, then it‘s the
most rational decision you can make. You should implement it to completely
solve your current problem or any other related problems in the future. If the
solution didn‘t solve your problem, then test another potential solution that you
came up with.
Dependency of Rationality on Time Horizon:

An investment time horizon, or just time horizon, is the period of time one
expects to hold an investment until they need the money back. Time horizons
are largely dictated by investment goals and strategies. For example, saving for
a down payment on a house, for maybe two years, would be considered a short-
term time horizon, while saving for college would be a medium-term time
horizon, and investing for retirement, a long-term time horizon.

 Time horizons are periods where investments are held until they are
needed.
 Time horizons vary according to the investment goal, short or long.
 Time horizons also vary according to the time by which you begin
investing.
 The longer the time horizon, the longer the power of compounding has to
work.
 Generally speaking, the longer the time horizon, the more aggressive an
investor can be in their portfolio, and vice versa.

An investment time horizon is the time period where one expects to hold an
investment for a specific goal. Investments are generally broken down into two
main categories: stocks (riskier) and bonds (less risky). The longer the time
horizon, the more aggressive, or riskier, a portfolio an investor can build. The
shorter the time horizon, the more conservative, or less risky, the portfolio the
investor may want to adopt.

Short-Term Investment Horizon

The short-term horizon refers to investments that are expected to last for fewer
than five years. These investments are appropriate for investors who are
approaching retirement or who may need a large sum of cash in the near future.
Money market funds, savings accounts, certificates of deposit, and short-term
bonds are good choices for short-term investments since they can easily be
liquidated for cash.

Medium-Term Investment Horizon

Medium-term investments are those which one expects to hold for three to ten
years, such as by people saving for college, marriage, or a first home. Medium-
term investment strategies tend to balance between high- and low-risk assets,
so a mix of stocks and bonds would be a suitable way to protect your wealth
without losing value to inflation.

Long-Term Investment Horizon

The long-term investment horizon is for investments that one expects to hold
for ten or twenty years, or even longer. The most common long-term
investments are retirement savings. Long-term investors are typically willing to
take greater risks, in exchange for greater rewards.

Herbert Simon and Bounded Rationality:

Herbert A. Simon (1916–2001) was an American economist and political

scientist who won the Nobel Memorial Prize in Economic Sciences in 1978 for
his contributions to modern business economics and administrative research.
He is widely associated with the theory of bounded rationality, which states
that individuals do not make perfectly rational decisions because of both
cognitive limits (the difficulty in obtaining and processing all the information
needed) and social limits (personal and social ties among individuals).

Simon earned his Ph.D. from the University of Chicago in 1943. After
graduating, he worked in research and held teaching posts at a handful of
universities before joining the Carnegie Mellon University faculty in 1949. He
taught there for more than 50 years, as a professor of administration,
psychology, and computer science. He also had a hand in the establishment of
several of Carnegie Mellon's departments and schools, including the Graduate
School of Industrial Administration, which is now known as the Tepper School
of Business.

In addition to the Nobel Memorial Prize in Economics, Simon received the

A.M. Turing Award in 1975 for his work in computer science, including his
contributions to the area of artificial intelligence. He also won the U.S.
National Medal of Science in 1986.

Simon authored dozens of journal articles and 27 books during his lifetime,
including "Administrative Behavior" (1947), "The Sciences of the Artificial"
(1968), and "Models of Bounded Rationality" (1982).

 Herbert A. Simon is widely associated with the theory of bounded

rationality.
 His theories challenged classical economic thinking on rational behavior.
 He won the Nobel Memorial Prize in Economics for his contributions to
modern business economics and administrative research.
Herbert A. Simon and his theories on economic decision-making challenged
classical economic thinking, including the ideas of rational behavior and the
atomistic individualism of economic man. Rather than subscribing to the idea
that economic behavior was rational and based upon all available information
to secure the best possible outcome for an individual ("optimizing"), Simon
believed decision-making was about achieving outcomes that were "good
enough" for the individual based on their limited information and balancing the
interests of others. Simon called this "satisficing." His term was a combination
of the words "satisfy" and "suffice."

According to Simon, because humans cannot possibly obtain or process all the
information needed to make fully rational decisions, they instead seek to use
the information they do have to produce a satisfactory result, or one that is
"good enough." He described humans as being bounded by their own
"cognitive limits."

In addition to cognitive limits, Simon also wrote about how personal relations
and social organizations constrain decision-making. This means that
individuals often do not make decisions considering only their own interests or
the individual's utility maximization, but must negotiate, exert power over, or
otherwise navigate the interests of others and the rules of the institutional
setting within which they operate.

Together these cognitive and social limits and the way they shape decision-
making are commonly known as the theory of bounded rationality. Under
bounded rationality, decision-makers must settle for finding satisfactory
solutions to the problem or problems in front of them, while being mindful of
how other decision-makers in the company are solving their own problems.
Within these bounds, decision-making can still be rational in that it consists of
comparing the relative costs, benefits, and risks to achieve a desired result.
Bounded rationality would also go on to become a foundational element
in behavioral economics, which at times also questions whether human
decision-making is really rational at all.

When the Royal Swedish Academy of Sciences awarded Simon the Nobel
Memorial Prize in Economics for his work in this area, it noted that much of
modern business economics and administrative research are based on his ideas.
Simon replaced the concept of the all-knowing, profit-maximizing entrepreneur
with the idea of cooperating decision-makers within a company who face
informational, personal, and social limitations.
Arbitrage:

Arbitrage is one of the oldest investment strategies. It's important for traders to
monitor activity on the market and note fluctuating prices of various assets.
Knowing how to identify arbitrage opportunities can allow you to gain profit
when conducting trades of stocks and other items. In this article, we discuss the
definition of arbitrage, how it works and the trading conditions necessary for
arbitrage to take place.

Arbitrage describes the act of buying a security in one market and

simultaneously selling it in another market at a higher price, thereby enabling
investors to profit from the temporary difference in cost per share. In the stock
market, traders exploit arbitrage opportunities by purchasing a stock on a
foreign exchange where the equity's share price has not yet adjusted for the
exchange rate, which is in a constant state of flux. The price of the stock on the
foreign exchange is therefore undervalued compared to the price on the local
exchange, positioning the trader to harvest gains from this differential.
Although this may seem like a complicated transaction to the untrained eye,
arbitrage trades are actually quite straightforward and are thus considered low-
risk.

Limits:

The question that remains to be answered is why arbitrage opportunities do not

quickly disappear even if investors know how to exploit them?. The idea is that
strategies designed to correct the mispricing can be both risky and costly.
Professors Thaler and Barberis (Thaler and Barberis ) have identified four risks
and costs that have been identified.

Fundamental Risk :

Fundamental risk refers to the risk that new bad information arrives to the
market after you purchased the security. Theoretically this risk could be
perfectly hedged by buying a closely related product. Unfortunately substitute
securities are rarely perfect, making it impossible to remove all the fundamental
risk.

As an example, suppose you own two shares, one from A, the other one from B.
Furthermore assume that both are closely related, share the same industry, and
that you buy A and sell B. After the combination of buying and selling, most
fundamental risk is removed. Intuitively, we can think of being neutral to the
industry where A and B operate. However, the investor is still vulnerable to bad
news about the industry as a whole. To sum up, fundamental risk always
persists even though there are ways of hedging the portfolio against it.

Noise Trader Risk :

Noise trader risk is very important because of its link to other agency problems.
It can force people, such as institutional investors and hedge fund managers, to
liquidate their positions early, bringing them unwanted and unnecessary steep
losses. Hence if investors lack the knowledge to evaluate the managers strategy,
they may simply evaluate him based on his returns. If a mispricing worsens in
the short run and generates negative returns, investors made decide to withdraw
their funds and force him to liquidate his business.

Implementation Costs Implementation :

costs are well known to any investor. They refer to transaction costs such as
commissions, bid-ask spread, premium costs for hot collateral in repurchase
agreements, increased commissions for shorting securities among others. Other
than monetary costs, there can also be legal constraints and accounting issues.
This category also includes the cost of finding and learning about a mispricing,
as well as the cost of the resources needed to exploit it. In particular, finding
mispricings can be expensive and time consuming. Learning about them will
certainly require highly specialized labor. Finally exploiting mispricing
furthermore requires state of the art technology and expensive IT systems that
can trade at the high-frequency speed.

Types:

There are different classifications of arbitrage, and hence different types of

arbitrage involved. One classification includes:

Financial arbitrage: Financial arbitrage typically refers to forex arbitrage

trading.

Statistical arbitrage: This method of arbitrage involves extensive usage of data

and statistics to tap into movement of price.
Dividend arbitrage: This is an arbitrage type wherein a trader (in the options
market) purchases stock and an equal number of put options before the next
dividend date. (ex-dividend). Dividend arbitrage is also called an options
arbitrage strategy.

Convertible arbitrage: This is one of the most popular types of arbitrage and is
all about buying a security that‘s convertible and short-selling the stock
underlying it. A convertible security refers to a security that can be converted
into another kind of security. For instance, it could refer to a bond that can be
converted/exchanged into a company‘s shares.

 Spatial arbitrage: The investors search for opportunities within markets

in different locations. For example, they may find stock for a restaurant
chain for a price in one state and a different price in another state.
 Cross-border arbitrage: Arbitrageurs take advantage of price
differences from markets in different countries. For instance, the cost of
an asset may be higher in Tokyo than it is in America.
 Triangular arbitrage: Traders notice a difference in the exchange rate
of currencies in three foreign countries. They convert a sum of money
into the currency of one country, convert it again to another currency,
then convert back to its original currency, gaining the profit. For example,
the trader would convert USD to Euros, Euros to JPY, then JPY back to
USD.

Cost involved in arbitrage process,

The model of limited Attention.

 Unit IV

Introduction Geomagnetic storm:

The geomagnetic storm (GMS) which gives rise to beautiful Northern lights is a
short lived disturbance in the earth‘s upper atmosphere or earth‘s
magnetosphere. It is caused by solar flares or solar winds that is intense
explosion from originating the visible segment of the sun‘s chromospheres
which disturbs magnetic field. These solar flares are known as plasma which is
made up of electrons and protons with the energy of earth of some thousands
electron volts. The substances which are come from these flares move through
the interplanetary medium. The speed of these flares is ranging from 1,000 to
2,000 km per second, and the expelled substances approaches the earth surface
in approximately 21 hours. The force of plasma is spread to the upper
circumference of magnetosphere of earth which causes the changes earths in
geomagnetic field. The large geomagnetic storms occur when the direction of
these charismatic fields surrounded by the planetary wind is directly
contradictory to the earth‘s charismatic field. On a regular basis sun produces
―bubbles‖ (coronal mass ejections) the speed of these bubbles is very fast.
These bubbles are denser than regular ones and hold elevated charismatic fields.
The movement of these type of bubbles is far away from the sun at a speed
around Two million miles per hour. When bubbles start from the sun to arrive at
earth, the distance travels by them are Ninety Three million mile in around forty
hours. Since sunspot activity occurs in around eleven years, so geomagnetic
storm displays some cycle as well.

OBJECTIVES

• To determine how Geomagnetic Storms impact every day returns of capital

market, deviations in the average returns, and change in investor‘s strategies.

• To determine the effect of geomagnetic storms on people's moods while

relating to the decisions, opinions and behavior of the people.

Phases of Geomagnetic :

Storm The phases of geomagnetic storm are divided into three parts which tells
about how geomagnetic storm occurs from initial phase to recovery phase,
which are as follows:
• Initial Phase: In the initial phase of geomagnetic storm, it is illustrated by
DISTURBANCE STORM TIME or SYM-H, which is a one minute component,
increased by twenty to fifty NT (in tens of minutes). Most of the geomagnetic
storm does not have an initial phased and there is no unexpected increase in
DISTURBANCE STORM TIME or SYM-H is follow by a geomagnetic storms.
The initial phase of geomagnetic storms is also known as Storm Sudden
Commencement (SSC). This phase is connected by means of density of the
magnetosphere, which results in an enhance in local strength. The period of this
phase can be up to 2-8 hours.

• Main Phase: The period of main phase of geomagnetic storm is about 12 to

24 hours. The main phase is about decreases in surrounding field intensities. In
this phase, geomagnetic storm is characterized in terms of DISTURBANCE
STORM TIME, typically less than -50 NT. Typically, the lower bound of
values during the course of storm is said to be in the range of -50 and -600 NT.
• Recovery Phase: This phase ranges from 10 hours to as much as 7 days. This
phase results from reconciliation between the lower and bound and normal
range of storm time.

Types of Geomagnetic :

Storms We generally talk about geomagnetic storms as being classified into two
major categories, namely, recurrent and non-recurrent storms. The detailed
explanation is as follows:
• Recurrent Storms: The periodicity in storms has a time period of 27 days.
These types of storms are typically seen in declining cycle of solar cycle. In the
interplanetary medium and specifically at the juncture of low- and high-speed
solar winds streams in the vicinity of the Sun, high-pressure magnetic fields are
generated. Recurrent storms are formed when the Earth is exposed to these
magnetic fields.

• Non-Recurrent Storms: These storms are typically seen when solar phase is
at its peak. Interplanetary disturbances due to coronal mass ejections (CMEs)
are the source of non-recurrent storms.

Causes of Geomagnetic:

Strom As discussed above, when there is change in the properties of solar wind,
they produce the magnetic storms. The occurrence of Geomagnetic storms is
due to the solar wind which restrains a magnetic field called the interplanetary
(IMF) and the direction of it is same as the direction of Earth‘s field on the
dayside. The disturbance of magnetic field occurs when these fields rotate
toward an opposed to parallel direction. Usually, the place of IMF is in the
ecliptic plane, which is typical is parallel to the Earth‘s magnetic equator. The
exoduses are very small from this average track which causes by revolution of
the skewed dipole magnetic field which occurs once in a day and the rotation of
the Earth around the Sun is once in a year. When there are changes in the route
of the IMF relative to the ecliptic, then it becomes a cause of large departures.
These changes are formed by several phenomenons‘ that initiate from the Sun.
The main causes of geomagnetic storm can be explained as follows.

•Solar Flare: An unexpected spark of intensity observed over the Sun's exterior
or the solar limb, which is interpret as a huge energy released up to 6 × 1025
joules of energy is called as solar flare. They are often in nature and sometimes
they are go behind by a colossal coronal mass ejection. It is the most
magnificent event which may cause a geomagnetic storm. With the explosion of
the solar flare which is present in the radiance of the Sun that discharges a huge
quantity of energy in the form of outward-streaming elements. The time taken
by these particles to reach earth and there it begins to influence the magnetic
field is approximately two days. The particles whose speed is slow discharge
earlier in the way of earth.

• Coronal Holes: One more incident is accountable for magnetic field, is the
survival of coronal holes in the region of the Sun. Coronal holes are the element
of the sun corona‘s and these holes are regularly change their shape because
corona is not even. The X-ray images of the sun have been taken in 1970 by the
U.S. Skylab astronauts, who found that the corona of the Sun is not only even
but also exposed by ―holes‖. Particles break away from with relatively easier.
These particles after coming from corona holes arrived at elevated velocities in
their outward expansion in contrast to regular solar wind elements and generate
speedy streams. These speedy streams intermingle with the slower-speed solar
wind released from areas which are without holes and release the same sloping
of the IMF as we have discussed above. Coronal holes continue for much 27-
day solar (equatorial) revolution and, as a consequence, produce recurring
geomagnetic storms, as we discussed in recurrent storms.

Effect of Geomagnetic Storm :

Energy produced by solar flares are very high in nature, which are also very
dangerous to living organisms because strong solar flares discharge very high
energy elements that produce poisonous emission which is harmful to human
health also. Although, the Earth‘s charismatic field and atmosphere protect the
earth‘s surface from the consequences of solar flares and other solar
movements. The most hazardous release from these flares is vigorous charged
elements (primarily high-energy protons) and electromagnetic emissions
(primarily x-rays).The upper atmosphere of the Earth‘s surface stopped the
flares from x-rays. Although, Earth‘s surface stopped some flares from x-ray,
but then also they do effect the Earth's ionosphere, which in turn effect some
radio interactions, navigations, damage satellites hardware, electricity grids,
pipelines and geologic exploration. The outer atmosphere of earth is heated by
the energetic ultraviolet radiation, which enhances the friction on Earth-orbiting
satellites, which reduces their duration in the orbit. The strong solar flares and
radio emissions, both changes in the atmosphere can degrade the accuracy of
Global Positioning System (GPS) dimensions.

Probable Impact It refers to that impact which is likely to be happening when

geomagnetic storm occurs, but it is not necessary that it affect the following
objects. So we can say that probable impact is most likely impact.

• Induced Currents –: Irregularities in power system voltage can be possible.

On some protection device false alarms may be elicit.

• Spacecraft: Automatically surface charging may experience; a large drag on

low Earth-orbit satellites and compass reading problems.

• Routing: Irregular satellite routing (GPS) troubles, including loss-of-lock

there may be enlarged in range error.

• Radio: Blinking of High Frequency (HF) radio may be occur.

BIOLOGICAL AFFECTS

As we have already discussed geomagnetic storm have affect on humans which

is also known as biological effects. In 1998 the study has been conducted and
concludes that there is a straight relation between the sun‘s planetary storms and
living organic effects. The channel which facilitates the solar flares i.e. charged
particles from sun to earth surface is the same channel which facilitates to
human disturbance. There is present of magnetic elements in both animals and
humans about them as similarly present around the earth as a shield.

PSYCHOLOGICAL EFFECT

CMEs are supposed to produce psychological effects in very low magnitude,

but nevertheless significant from research perspective. These psychological
effects are exemplified by annoyance, palpitations, mood alterations, and a
general feeling of being unwell. Some additional psychological effects include
cloudy thoughts and confusion. Although these singular and individual
psychological states may not be brought to bear on investor decisions, when
accumulated, their magnitude reaches a psychological threshold that could be
sufficient to affect gross investor decisions. It would be interesting to
investigate if the speculated psychological effects are towards the rational side
or not.

Geomagnetic storm and financial market:

From the different studies, we can predict that, there is a basic link between the
returns from capital market and pattern in geomagnetic activities. Findings
relating to medical don‘t permit us to recognize an exact association between
geomagnetic storm with psychosomatic disorder. According to, Belisheva et al.
(1995), Halberg et al. (2000), Zakharov and Tyrnov (2001), the researchers
found that in the recovery phase of the storms the effect of geomagnetic activity
is abnormally high. So to examine empirically the relationship between returns
of capital market at time (t) and Geomagnetic storm pointer at time (t−k), with
selection of (k) as provoked factor. As a result, we are taking GMS as a null
hypothesis, which has no effect on the capital returns but the alternative
hypothesis which is taken as psychological disorders, which brings lesser
returns on those days when the effect of geomagnetic activity is very high. From
the above discussion we can conclude that, the link between geomagnetic storm
and the capital market are not focus on the analysis of data probing.

Why the financial analysts examine a casual relationship among geomagnetic

storms and the capital market? The reason behind this, the intensity of
geomagnetic storm has insidious effects on human being health and behavior.
The researchers have concluded that there is a direct relation between
gloominess and nervousness, mood swings and normally great levels of
geomagnetic activities. The researchers has also stressed on psychological
disarray and fluctuating moods which have been seen to be more observant
behavior including judgments related to economic nature and extensive
misattribution. So we can say that, the inter relationship between the intensity of
geomagnetic storms, mood swings and misattribution affects the return of the
capital market. If the investors bend towards more to negative situations through
phases of strong geomagnetic activities, the investors will be more bias to trade
capitals on violent days. This results due to, investor‘s characteristic, their
worse mood incorrectly and perceived pessimistic economic prospects rather
than ecological conditions.

The affects of geomagnetic storm on the market participants is directly which

indirectly influence the overall market returns. The demand for riskless assets is
quite high due to negative future prediction which ultimately causes the prices
of riskier assets to fall or the price will rise very steady. Therefore, the
conclusion of this description is a pessimistic fundamental link between pattern
in geomagnetic activities and returns from capital market.

While calculating capital market returns we should consider 4 United States

index such as the S&P500, NASDAQ, the NYSE, and the Amex. All these
indices do not include dividends, as they are value-weighted. US capital
markets indices consist of dividends and to analyze we also got qualitatively
identical results and these indices are taken from CRSP indices of returns. To
investigate small capitalization versus large capitalization capitals due to the
effect of geomagnetic storms, we should give an attention on the NASDAQ, the
Amex, the S&P 500, and the NYSE size deciles from CRSP

Impact of geomagnetic storm on stock market return:

From the above data we can conclude that, from November, 1960 the returns
are increasing gradually day by day, on 10 November 1960 the returns are
higher. On 12 November 1960, the geomagnetic storm has come and after that
there is a tremendous decline in the returns and returns remain low aftermath
effect of geomagnetic storm. After 3 to 4 days of geomagnetic storm effect, the
return will increase but on a slow pace as compare to its decline. In the second
table, more recent trends are presented.

In the above figure, there is comparison of returns of world and Canada,

NASDAQ and SP500. The green bar shows the returns during a normal day of
trading and red bar shows the return during bad days i.e. aftermath effects of
geomagnetic storms. From both graphs, we can conclude that returns decline
tremendously after the geomagnetic storm i.e. in normal days of trading the
NASDAQ returns is approximately 6% but after geomagnetic storm it decreases
which is approximately less than 1%. So there is a big dissimilarity between the
returns of normal days and bad days. So we can conclude that, geomagnetic
storm has very bad affect on human beings, communications and as well as on
the returns of capital markets.

Factors influencing stock & stock market:

1. Internal Development
2. World Events
3. Interest Rates
4. Exchange rates
5. Hype
6. Inflation and Deflation
7. Economic growth
8. Stability
9. Confidence and expectations
10.Bandwagon effect
11.Related markets
12.Other factors

External factors and investors behaviour:

Information Search:

The risk which is faced while making investments creates individual wealth.
Due to uncertainty, the investors must face financial loss. The uncertainty of
return is lowered when market information is obtained and managed properly.
Risk taking theory develops different plans to minimize risk in investment
decisions including looking for and obtaining more and more market
information to lessen uncertainty of these decisions.

Overconfidence Bias :

Bias causes to show inclination for or against someone or something. In finance,

bias is a tendency of the investor to make financial decision while he already
has a faith and trust. In making investment judgements in stock exchanges and
firms an important role is played by these biases in framing investor decisions

Confidence is self-assurance that arises from approval of one‘s own skills,

judgement and abilities. It is an internal feeling of a person about himself.
Overconfidence is prejudiced way to come across a situation. If a person is
overconfident, he over estimates his skills, knowledge, beliefs and judgements
and show more confidence than needed in a situation. This overconfidence
makes investors think that the investment decisions of other persons are caused
by their emotions, perceptions, feelings and moods. But they take their own
decisions a result of purposeful and sensible ideas. This attitude leads them to
such a level that they find all the stuff in their support but opinions of others as
illogical and insensible. They do not care much about the level of risk that is a
part of their financial plan. These individuals trade excessively. They do not
only trade more but their exposure to risk is also higher. Overconfidence is not a
negative phenomenon always. Those who criticize this bias claim that practice
of overconfidence leads towards more trade by investors reducing the efficiency
of the market as they do not focus risk in investment in a proper way rather they
overvalue the expected return and do not pay any attention to realism of market.
But another group of critics feel that efficiency of the market is improved
because of overconfidence bias as a lot of information is gathered by them.
Different opinions of the experts on the influence of overconfidence bias on
market efficiency have made this bias controversial and attractive for further
research. This study determines the impact of overconfidence on investment
decision making behavior and its relationship with information search..

Economic Expectations :

Economic expectations can be defined as forecasted expectations about

economy that what type of the performance a firm will show in the coming
period i.e. next month, next year or other duration. These expectations can
consist of anticipations about level of employment, output and expansion of the
organization, balance of trade and inflation rate in the economy. Economic
expectations play a prominent role in investment decision making. These
expectations are both about company‘s future earnings and country‘s overall
economic conditions. Some well-known factors that affect financial decisions of
investment are performance of the firm in previous years, anticipated increment
of capital and bonus, dividend distribution plans and anticipated profits of the
firm etc. The decisions of individual investors regarding firm‘s investment
products are influenced by the economic and social features of investors i.e. sex,
age, being single or married, experience of investment and their education level.

Rational Expectations Theory :

An economist, Robert Lucas who belongs to United States worked on this

rational expectation theory which was originally presented by (Muth, 1961). It
is defined as a concept that investors take investment decisions which are
supported by their rational viewpoints, the experience they have and the
information in hand. According to this theory recent economic expectations
show the condition of economy in the upcoming period. This concept weakens
the prevalent opinion that investor decisions are affected by policies of the
government. These investors predict decisions that will be taken by the
government in the future by comparing past performance of the authorities.

Prospect Theory :

Prospect Theory, a behavioral economic theory describes making investment

decisions in the presence of risky environment. This theory opines that when
investors must choose among investment opportunities they pass from two
different steps. The investors are supposed to revise a difficult judgement to an
effortless and easy decision in the first step. This decision is simply based on
income and loss. The next step is to make a choice from the simplified decisions
formed in the first step. The decision of choosing edited option involves two
proportions which include the obvious value of every aspect and weight
allocated to these values. When a complicated decision has been divided in
these two attributes, the subsequent step to follow is to combine them by the
investor.

Factors influencing on investors behaviour:

Personal Factors :

Personality is the characteristic integration of behavior patterns, interests and

tendencies, talents and orientations. As personality traits are important from a
behavioral point of view, these personality traits also become important in terms
of finance in the outcome of the anticipation of the actions taken in investment
decisions.

Financial Factors :

The financial factors that are effective in investing the deposits of individuals in
their hands can be listed as cash flow, risk, liquidity, return ratios and
investment duration. Savers are constantly refraining from inflation while
investing. Because even if inflation causes an increase in the book value of the
assets, this increase will not cause the equity price of the entity to increase.

Environmental Factors :

Environmental factors are groups of socio-cultural environment, close

environment, family and other environmental impacts that are affected by
investors' investments. Individuals' attitudes and thoughts are largely influenced
by the cultures they live in. In other words, the sociocultural situation of the
individual also affects the decision-making process. Because individual
investors do not have enough knowledge about investment instruments, they
want to get the approval and thought of the decision makers.
 Unit V: Corporate Behavioral Finance:

Introduction:

Corporate decision making: Heuristic approach, prospect theory, market

variables, herding effect :

Heuristic approach:

Heuristics play important roles in both problem-solving and decision-making, as

we often turn to these mental shortcuts when we need a quick solution.

Here are a few different theories from psychologists about why we rely on
heuristics.
  Attribute substitution: People substitute simpler but related questions in
place of more complex and difficult questions.
 Effort reduction: People use heuristics as a type of cognitive laziness to
reduce the mental effort required to make choices and decisions.2
 Fast and frugal: People use heuristics because they can be fast and
correct in certain contexts. Some theories argue that heuristics are
actually more accurate than they are biased.

Prospect theory:

Prospect theory is a psychology theory that describes how people make

decisions when presented with alternatives that involve risk, probability,
and uncertainty. It holds that people make decisions based on perceived losses
or gains.

Features of the Prospect Theory

The prospects theory comes with the following characteristics:

1. Certainty

When presented with several options to choose from, humans show a strong
preference for the option with certainty. They are willing to sacrifice the option
that offers more potential income in order to achieve more certainty. For
example, assume that a lottery provides two options, A and B.

Option A provides a guaranteed win of $100 while option B provides the

possibility of winning $200, with a 70% chance of winning and 30% chance of
losing. Most people will choose option A since it provides a guaranteed win,
even though it offers a lower return compared to B.

2. Small probabilities

People tend to discount very small probabilities even if there is a possibility of

losing all their wealth. By discounting the small probabilities, people end up
choosing higher-risk options with higher probabilities.

3. Relative positioning

Relative positioning means that people tend to focus less on their final income
or wealth, and more on the relative gains or losses that they will get. If their
relative position does not improve with increases in income, they will not feel
better off. This means that people tend to compare themselves to their
neighbors, friends, and family members, and are less interested in whether they
are better off than they were some years back.

For example, if everybody in the office gets a 20% raise, no individual will feel
better off. However, if the person gets a 10% raise, and other people fail to get a
raise, that person will feel better off and richer than everyone else.

4. Loss aversion

People tend to give more weight to losses rather than gains made by taking a
certain option. For example, if a person makes $200 in profits and $100 in
losses, the person will focus on the loss even though they emerged with a $100
net gain. This shows that people are more concerned about losses rather than
gains.

Market variables:

1 - Market Research. According to economist Rob Hyndman, to be successful,

every business needs to be familiar with the market environment and this is why
research is necessary in order to obtain necessary information.
The scholar explains that business organizations need to always pay attention to
what is happening in the business world, what are the trends among consumers
and what is demanded the most. By assessing the relevant information, business
people take adequate steps to respond to specific demand by consumers. For
example, after exploring the market, the Taiwanese technology producer HTC
incorporated the Android software in its mobile devices. This step boosted the
sales of HTC products due to the high popularity of the Android operating
system.

2 - Competition. Competition is another factor that strongly influences decision

making processes within businesses. Since the market nowadays is highly
competitive, business people always pay attention to the business operations of
their rivals. For example, when Apple released its iPad tablet, Samsung quickly
responded by releasing its Galaxy Tab which proves that while taking decisions
on future developments, businesses consider competitors and their business
development plans.

3 - Economic Environment. The Economic environment is particularly

important because it is related to the buying capacity of customers and what
products the people, in general, would afford. When taking decisions, business
people bear in mind that they must comply with some standard and not, for
instance, impose high prices on their production in times of financial recession.
For example, Apple produces the iPhone mobile devices which are more
expensive than similar devices by other brands. However, when major
consumer states like the UK entered into severe financial crisis in the beginning
of 2011, the company announced that it is developing a cheaper version of the
iPhone that would respond to the economic environment in countries where
there are financial problems.
4 - Social Responsibility. Social responsibility towards customers is also a
factor that influences business decision making. Economist Paul Hohnen from
the International Institute for Sustainable Development emphasizes that its
concept is that business must be acting for the common good and in the interest
of the general public. For example, UK legislation does not allow banks to
impose unreasonably high fees on customers who are late with their mortgage
payments. This legislation is followed by leading banking institutions in the UK
such as HSBC and Lloyds TSB.

5 - Cost and Benefit. Financial expert April Dmytrenko highlights that for
successful business decision making, it is required that business bodies create
cost and benefit analysis. This approach takes into account expenses for the
business from the process of production and revenue that would be generated
when the product is put on sale. Thus business people are able to determine
whether certain products would be a good business opportunity. For example,
before releasing the Chevy Volt hybrid car, the business developers in
Chevrolet analyzed a detailed cost and benefit plan. It determined that the
revenue from Volt hybrid sales would justify the expenditures of its production.

Herding effect:

The term herd instinct refers to a phenomenon where people join groups and
follow the actions of others under the assumption that other individuals have
already done their research. Herd instincts are common in all aspects of society,
even within the financial sector, where investors follow what they perceive
other investors are doing, rather than relying on their own analysis.1

In other words, an investor who exhibits herd instinct generally gravitates

toward the same or similar investments as others. Herd instinct at scale can
create asset bubbles or market crashes via panic buying and panic selling.

 A herd instinct is a behavior wherein people join groups and follow the
actions of others.
 Herding occurs in finance when investors follow the crowd instead of
their own analysis.
 It has a history of starting large, unfounded market rallies and sell-offs
that are often based on a lack of fundamental support to justify either.
 The dotcom bubble of the late 1990s and early 2000s is a prime example
of the effects of herd instinct.
 People can avoid herding by doing their own research, making their own
decisions, and taking risks.

Empirical data on presence and absence of dividend:

Ex-Dividend day behaviour:

Timing of corporate news announcement:

Behavioral life cycle:

Self-control, mental accounting, and framing are incorporated in a behavioral

enrichment of the life-cycle theory of saving called the Behavioral Life-Cycle
(BLC) hypothesis. The key assumption of the BLC theory is that households
treat components of their wealth as nonfungible, even in the absence of credit
rationing. Specifically, wealth is assumed to be divided into three mental
accounts: current income, current assets, and future income. The temptation to
spend is assumed to be greatest for current income and least for future income.
Considerable empirical support for the BLC theory is presented, primarily
drawn from published econometric studies.