Behavioral Finance

Unit 5
Behavioural Finance
• Behavioural Finance (BF) is the study of investors’ psychology while
making financial decisions. It is the study of the influence of
psychology and sociology on the behaviour of financial practitioners
and the subsequent effect on market.
• Behavioural finance focuses upon how investor interprets and acts on
information to take various investment decisions.
• Behavioural finance can be explained as modern finance in which it
seeks the reasons of stock market anomalies by justifying them with
explanation of various biases that the investor has while taking
investment decisions.
TRADITIONAL FINANCE AND
BEHAVIOURAL FINANCE
TRADITIONAL FINANCE BEHAVIOURAL FINANCE
• Traditional finance assumes that • Behavioral finance recognizes that
people process data appropriately people employ imperfect rules of
and correctly. thumb (heuristics) to process data
which induces biases in their belief and
• Traditional finance presupposes predisposes them to commit errors.
that people view all decision • Behavioral finance postulates that
through the transparent and perceptions of risk and return are
objective lens of risk and return. significantly influenced by how decision
Put differently, the form (or frame) problem is framed. In other words,
used to describe a problem is behavioural finance assumes frame
insignificant. dependence
TRADITIONAL FINANCE AND
BEHAVIOURAL FINANCE
TRADITIONAL FINANCE BEHAVIOURAL FINANCE
• Traditional finance assumes that • While, behavioural finance,
people are guided by reasons recognises that emotions and herd
and logic and independent instincts play an important role in
judgment. influencing decisions.
• behavioural finance contends that
• Traditional finance argues that
heuristic-driven biases and errors,
markets are efficient, implying frame dependence, and effects
that the price of each security is emotions and social influence often
an unbiased estimate of its lead to discrepancy between market
intrinsic value. price and fundamental value.
TRADITIONAL FINANCE AND
BEHAVIOURAL FINANCE
TRADITIONAL FINANCE BEHAVIOURAL FINANCE
• Traditional finance views that • behavioural finance views that prices
price follow random walk, are pushed by investors to
though prices fluctuate to unsustainable levels in both
direction. Investor optimists are
extremes, they are brought back disappointed and pessimists are
to equilibrium in time. surprised. Stock prices are future
estimates, a forecast of what
investors expect tomorrow’s price to
be, rather than an estimate of the
present value of future payment
streams.
Behavioural Biases that Influence
Investment Decisions
• Denial: Most of the times investors do not want to believe that the stock they
have held since ages has become under-performing or they need to sell it off.
They are in a constant state of denial. Even through the said asset brings the
overall return of the portfolio down, investors are reluctant to part with it.
• Information processing errors: Often referred to as the heuristic simplification,
information-processing error is one of the biases of investor psychology. These
people use the simplest approach to solve a problem rather than depending on
logical reasoning. Heuristic simplification can be detrimental to the investing
decisions. This is done by omitting crucial information to reduce complexity and
processing only part information. Such an approach can lead to flawed
decisions which can be dangerous to the stock market.
Behavioural Biases that Influence
Investment Decisions
• Emotions: Most of the behavioural anomalies stem from extreme
emotions of the investors. This happens when investors do not make
decisions with an objective mind and only tend to respond to their biases.
Misconceptions, misinterpretations, risk-aversion, past experiences all
combine to block the logical bent of mind and exposes the investment d
• Loss Aversion: The risk-taking ability of each investor is different. Some
are conservative in their approach while others believe in taking
calculated risks. However, among the conservative investors are few who
fear losses like anything. They may be aware about the potential gains
from an asset class but are intimidated by the prospects of incurring even
a short-term loss.
Behavioural Biases that Influence
Investment Decisions
• Social influence/herd mentality: Herding is quite an infamous phenomenon in
the stock markets and is the result of massive sell offs and rallies. These
investors do not put in deep research behind their decisions and only follow the
sentiment of the crowd whether positive or negative. Whether it was the tech-
bubble in the early 90s, the subprime crisis in 2008, the Eurozone crisis in 2010
or the recent banking sector scams in India, the market has seen huge sell-offs.
• Framing: According to the Modern Portfolio Theory, an investment cannot be
evaluated in isolation. It has to be viewed in the light of the entire portfolio.
Instead of focusing on individual securities, investors should have a broader
vision of wealth management. However, there are investors who single out
assets or a particular investment for evaluation. This is viewing at things
through a “narrow frame”.
Behavioural Biases that Influence
Investment Decisions
• Anchoring: Many a time investors hold on to a particular belief and
refuse to part ways with it. They “anchor” their beliefs to that notions
and have difficulty in accepting any new piece of information related
to the subject. This is true in cases wherein a real estate or
pharmaceutical company is involved in a legal battle or bank has been
involved in a scam. This negative information is received with greater
intensity, so much so that no other piece of positive information can
neutralize its effect.
Heuristics
• Many decisions are based on beliefs about the probability of uncertain events
such as the outcome of an R&D project or the future value of the rupee.
These beliefs are usually expressed in statements such as “I think that the
prospects are really bright”.
• The subjective assessment of probabilities is typically based on data of limited
validity, which are processed according to heuristics or simple rules of thumb
that lead to biases. The most important heuristics are:
• Representativeness
• Availability heuristic
• Anchoring and adjustments
• Affect heuristic
Affect Heuristic
• The Affect Heuristic The likes and dislikes of people determine their
beliefs about the world.
• People judge an activity or an alternative not just on what they think
about it but also on how they feel about it.
• As Michael Mauboussin put it, “If they like an activity, they are moved
toward judging the risks as low and benefi ts as high and vice versa.
Under this model, affect comes prior to, and directs, judgments of risk
and benefi t.” The affect heuristic is an example of substitution. A
harder question (How do I think about it?) is substituted by an easier
question (How do I feel about it?).
Representativeness
• Representativeness refers to the tendency to form judgments based
on stereotypes. For example, you may form an opinion about how a
student would perform academically in college on the basis of how he
has performed academically in school. While representativeness may
be a good rule of thumb, it can also lead people astray. For example:
• Investors may be too quick to detect patterns in data that are in fact
random.
• Investors may believe that a healthy growth of earnings in the past
may be representative of high growth rate in future. They may not
realise that there is a lot of randomness in earnings growth rates.
Representativeness
• Investors may be drawn to mutual funds with a good track record
because such funds are believed to be representative of well-
performing funds. They may forget that even unskilled managers can
earn high returns by chance.
• Investors may become overly optimistic about past winners and
overly pessimistic about past losers.
• Investors generally assume that good companies are good stocks,
although the opposite holds true most of the time.
Availability heuristic
• People tend to judge the frequency of something by the ease with
which instances can be recalled. Like other heuristics of judgment, the
availability heuristic substitutes the harder question (How likely an
event is?) with the easier question (Have I seen something like this?).
The availability heuristic says that events that can be easily recalled
are deemed to occur with higher probability.
ANCHORING and Adjustment
• While making a quantitative judgment, people are subconsciously anchored
to some arbitrary stimulus.
• Kahneman and Tversky carried out a famous experiment called the “Wheel of
Fortune” experiment in 1974 to demonstrate the phenomenon of anchoring.
Participants in this experiment were shown the number generated by the
Wheel of Fortune and then asked what percentage of African nations were
members of the U.N. The answers given by them were influenced by the
random number thrown up by the Wheel of Fortune, although it had no
relevance whatsoever to the question asked.
• When people are asked to estimate something, they usually start with an
initial value and adjust it to generate the fi nal estimate. The adjustment,
however, is often inadequate.
Prospect theory
• The prospect theory was proposed by Kahneman and Tversky
• 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.
• Tversky and Kahneman proposed that losses cause a greater emotional
impact on an individual than does an equivalent amount of gain, so given
choices presented two ways—with both offering the same result—an
individual will pick the option offering perceived gains
Example of Prospect Theory

• Consider an investor who is given two pitches for the same mutual fund.
The first advisor presents the fund to Sam, highlighting that it has an
average return of 10% for the last three years. Meanwhile, a second
advisor tells the investor that the fund has had above-average returns
over the last decade, but has been in decline for the last three years.
• Prospect theory says that although the investor has been pitched the
exact same mutual fund, they are likely to buy from the first advisor. That
is, the investor is more likely to buy the fund from the advisor that
expresses the fund's rate of return in terms of only gains, while the
second advisor presented the fund as having high returns, but also losses.
Value Function and prospect theory
The key elements of prospect theory
• Reference dependence: people derive value from gains and losses
relative to some reference points, rather from absolute level of
weights
• Diminishing sensitivity: people feel good when they gain but twice the
gain dose not make them feel twice as good. People experience pain
when they loose but twice the loss does not mean twice the pain.
• Loss aversion: the value function is steeper for losses than for gains.
This means people feel more pain from the loss than the pleasure
from gain. About two and a half times strongly.