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06.chapter 2
06.chapter 2
Introduction:
The discussion in this part of the thesis is focused on the various dimensions
of Behavioral Finance and Behavioral Biases viz.
Introduction:
Behavioral finance study the effects of social, cognitive and emotional factors
on the economic decisions of individuals and institutions and the consequences for
market prices returns, the resource allocation in the investment field are primarily
concerned with the bonds of rationality of economic agents. Behavioral model,
typically integrate insights from psychology with neoclassical economics theory. In
this direction Behavioral models cover a range of concepts methods and fields.
Behavior finance has been perceived by different writers in varied ways. Some
authors perceived behavioral finance as the study of the influence of psychology on
the behavior of practitioners and the subsequent effect on markets. The science deals
with theories and experiments focused on what happens when investors make
decisions based on hunches and emotions. Shefrin (2000) comprehends behavioral
finance as a rapidly growing art that deals with the influences of psychology on the
behavior financial practitioners. Belsky and Gilovich (1999) emphasizes that
behavioral economics explain why and how people make seemingly irrational or
illogical decisions when they spend, invest, save and borrow money. Barber and
Odean (1999) have observed ―Behavioral finance relaxes the traditional assumption of
financial economics by incorporating these observable systematic by incorporating
these observable systematic and very human departures from rationality into standard
models of financial markets. The tendency for human beings to be overconfident
causes the human desire to avoid regret prompts the second.‖ Fama (1998) has
described ―Behavioral finance‖ as a field of finance that proposes explanation of stock
market anomalies using identified psychological biases rather than dismissing them as
―chance results consistent with the market efficiency hypothesis‖.
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Behavioral Finance Evolution of the Discipline:
PSYCHOLOGY SOCIOLOGY
BEHAVIOURAL FINANCE
FINANCE
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Behavioral finance is comprehended in the following ways:
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Traditional finance assumes that people are guided by reasons and logic and
independent judgment whereas behavioral finance recognizes that emotions
and herd instincts play on important role in influencing decisions.
Traditional finance argues that markets are efficient implying that the price of
each security is an unbiased estimate of its intrinsic value. Behavioral finance
contends that heuristic driven biases and errors form effects on emotions and
social influence often lead to discrepancy between market price and
fundamental value
Traditional finance views that price follow random walk though prices
fluctuate to extent they are brought back to equilibrium in time. Behavioral
finance views that prices are pushed by investors to unsustainable levels in
both directions. Investor optimists are disappointed and pessimists are
surprised.
1. Investors
2. Corporations
3. Markets
4. Regulators
5. Education
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Behavioral Finance and Investment Decisions:
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Prospect Theory:
The theory was originally conceived by Kahneman and Tversky (1979) and
later resulted in Daniel Kaheman being awarded the Nobel Prize for Economics. The
work by the authors is considered as path breaking in behavioral finance. They
introduced the concept of prospect theory for the analysis of decision making under
risk. This theory is considered to be seminal in the literature of behavioral finance. It
was developed as an alternative model for expected utility theory. It throws light on
how individual evaluate gain or losses. The theory has three key aspects.
The value function in the prospect theory replaces the utility function in the
expected utility theory. Further instead of using simple probabilities as in the expected
utility theory it uses decision weights which are a function of probability. The
following figure shows the value function of the prospect theory the S-shaped value
function depicted in the figure is the central element of the prospect theory.
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Value
Reference Point
The shape of the S shaped valued function is concave in the region of gain and
convex in the loss region reflecting risk aversion in the domain of gains and risk
seeking in the domain of losses. The interesting property of the value function is that
it is steepest at the reference point. It implies that a given change in gains or losses has
a smaller effect on the value experienced by an investor when the distance to the
reference point is large. Prospect theory maintains that when choosing between
gambles people compare the gain and losses for each one and selects the one with the
highest perspective utility. This argument indicates that people may choose a portfolio
allocation by computing for each allocation the potential gains and losses in the value
of their holdings and then taking the allocation with the highest prospective utility.
Prospective theory has another element relating to weighing function. The value of
each outcome is multiplied by decision weight. Decision weight measures the impact
of events on the desirability of an investment. Kahneman and Tversky (1979) call this
property as sub certainly decision weight age generally repressive with respect to true
probabilities implying that preferences are less sensitive to variations in probability
than the rational benchmark would suggest. Prospect theory describes several states of
mind that can be expected to influences on individual‘s decision making process.
Heuristics:
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reduce complex problem solving to more simple judgmental operations (Tversky and
Kahneman 1981). Heuristic decision process is the process by which the investors
find things out for themselves usually by trial and error lead to the development of
rules of thumb. In other words it refers to rules of thumb which humans use to make
decisions in complex uncertain environment (Brabazon 2000). Heuristics is relevant
in modern trading when the number of instrument and the density of information have
increased significantly. Using heuristics allows for speeding up the decision making.
Traditional financial models assume the exclusion of heuristics and assume all
decisions being based on rational statistical tools. (Shefrin -2000)
Behavior Biases:
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1) Overconfidence Bias:
Overconfidence bias has been considered as the most basic form by Pompian
(2006), Overconfidence according to him can be measurable as unwarranted faith in
ones intuitive reasoning, judgment and cognitive abilities. Overconfidence derives
from a large body of cognitive psychological experiments both their own predictive
abilities and the precision of the information they have been given. Shefrin (2000)
comprehends that overconfidence pertains to how well people understand their own
abilities and the limits of their knowledge. A common trait among investors is a
general overconfidence of their own ability when it comes to picking stock and to
decide when to enter or exit a position. Odean (1998) researched these tendencies and
found that traders that conducted the most trades tended on average to received
significantly lower yields than the market. Barber and Odean (2000) partitioned
investors based on gender and based on the previous psychological research found
that men are more overconfident than women and overconfident investors trade
excessively.
2) Representativeness Bias:
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good characteristic of its stock. These companies turn out to be poor investments
more often than not (Lokonishok et al 1994)
3) Herding Bias:
In the security market herding investors base their investment decisions on the
masses decisions of buying or selling stocks. In contrasts informed and rational
investors usually ignore following the slow of masses and this makes the market
efficient. Herding causes a state of inefficient market which is usually recognized by
speculative bubbles.
4) Anchoring Bias:
Anchoring bias comes into play when people have to estimate an unknown
value or magnitude. Here people start their estimation by guessing some initial values
or an ‗anchor‘. This anchor is then adjusted and refined to arrive at the final estimate.
Compbells and Sharpes (2007) have investigated the presence of anchoring bias in
analysts‘ forecasts of monthly economic release for a period 1991 to 2006 and found
that forecasts of any given release were anchored towards recent months realized
values of that release thereby giving rise to predictable surprise.
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‗rational‘ when required to estimate a good buy price for a share and lives for is likely
to start by using an initial values called the ‗anchor‘ without much analysis then they
adjust ‗anchor‘ up or down to reflect their analysis or new information. But studies
have shown that this adjustment is insufficient and ends producing results that are
biased. Investors exhibiting this bias are likely to be influenced by these anchors
while answering key questions like ―Is this a good time to buy or sell the stock or is
the stock fairly priced? The concept of Anchoring can thus be explained by the
tendency of investors to ‗anchor‘ their thoughts to a logically irrelevant reference
point while making on investment decision (Pompian 2006).
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view of the real picture ii) selective decision making investors are likely to reinforce
commitment previously made even though it might be visible that it is the wrong
thing to do. This occurs because of commitment to the original decision forcing the
investor to rationalize actions which would allow him to stick to it even though these
actions are suboptimal.
6) Regret Aversion:
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7) Gambler‟s Fallacy:
Mental accounting was coined by Richard Thaler (1999) and defined by him
as the ―set of cognitive operations used by individuals and households to organize,
evaluate and keep intact of financial activities. Mental accounting is described as the
tendency of people to place particular event into different mental account based on
superficial attributes (Shiller -1998)
Mental accounting can serve to explain why investors are likely to refrain for a
stock (Shefrin and Statman 1985) this result in a tendency for people to separate
accounts based on a variety of subjective reasons. Individuals tend to assign different
functions to each asset group which has an often irrational and negative effect on their
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consumption decisions and other behaviors. Mental accounting refers to the codes
people use when evaluating an investment decision.
9) Hindsight Bias:
Shiller (2000) has described Hindsight bias as ―the tendency to think that one
would happen had once been present then or had (2009) investigated the relationship
between investment decision making and Hindsight bias. They maintain that
economic studies consider the agent‘s foresight perspective only without taking into
account the Hindsight bias possible effects in the decision making process. They
collected data from 25 master and Ph.D.. students attending courses in Finance and
Economics at Bocconi University and from 35 financial Managers from a leading
Italian bank by circulating two sets of questionnaire. Their study found strong
evidence for the consequence that Hindsight bias can have on the investor‘s decisions
the portfolio allocation perception and therefore the risk exposure.
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