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BEHAVIOURAL FINANCE Note PDF
BEHAVIOURAL FINANCE Note PDF
Theory and Market Efficiency: The pricing of risk – overall market that
Market efficiency – Agency Theory – Prospect contradict the efficient
Theory – Challenges to market efficiency – market hypothesis
Behavioural v/s Neo Classical Finance – Irrational
Preference and Cumulative Prospect Theory Definition of Behavioural Finance:
Behavioural finance is a relatively new field that seeks
Introduction to Behavioural Finance to combine behavioural and cognitive psychological
Finance emerged as a separate discipline from theory with conventional economics and finance to
Economics in late 1950’s and early 60’s. In the provide explanations for why people make irrational
traditional finance theories, the central assumption is financial decisions. “Behavioural finance, an offshoot
that people are rational. Rational investors are those of behavioural psychology, looks at the economic
who take decisions by evaluating risk and returns. decision making process of investors including
They will try to minimize risk and maximize returns engrained thought patterns and behavioural biases, and
and will try to act to protect self interest. Traditional its impact upon the performance of securities and
finance theories are also based on the assumption that markets”. In 2002, Daniel Kanheman and Vernon
markets are efficient. Traditional finance theories are Smith had won Nobel Prize for their work in
‘normative’ in nature and they suggest ‘how to behave behavioural finance. They have found that investors’
in an investment scenario’ rather than going for a decisions are guided by shortcuts and emotional filters.
positive approach which suggest ‘how will they
actually behave’. Linter G (1998) “Behavioural finance is the study of
Human behavior is diverse and complex and, how human interprets and act on information to make
unfortunately, despite our best intentions, it is not informed investment decisions”
always governed exclusively by rationality. In
particular, our judgment and decision-making can be Olsen R (1998) asserts that behavioural finance seeks
significantly affected by intuition, a form of abstract, to understand and predict systematic financial market
automatic thinking that can override our reason.
implications of psychological decision process.
Decades of research in psychology have shown that Assumptions of Behavioural Finance:
intuition is often systematically biased, and follows 1. Loss Aversion – Seek to limit the size of potential
identifiable patterns, causing us to reach conclusions loss rather than seek to minimise the variability of
that are predictable wrong, since they are based on our potential returns
gut or instincts, rather than on logic. An important
2. Bounded rationality – The manner in which humans
aspect of behavioral biases is that they affect us in behave limits their rationality
areas of our lives where it is very important that we be
3. Denial of risk – They may know statistical odds but
purely rational, such as in investing. The decisions refuse to believe these odds.
taken by humans are influenced by cognitive biases,
Standard Finance / Behavioural Finance
emotional filters and emotional shortcuts. This results
Neoclassical Finance
in irrational patterns in the market.
1 Assumes that people People employ imperfect
process data rules of thumb
Behavioural Finance is the field of study which argues appropriately and (heuristics) to process
that people are not nearly as rational as traditional correctly data
finance theory makes out. For investors who are
2 Assumes that people Perceptions of risk and
curious about how emotions and biases drive share
view all decisions returns are significantly
prices, behavioural finance offers some interesting
through objective lens influenced by how
descriptions and explanations. Behavioural finance is
of risk and return decisions are framed
commonly defined as the application of psychology to
3 People are guided by Emotions and herd
understand human behaviour in finance or investing.
reasons and logic and behaviour play an
independent important role
To make things easy, we will take the traditional judgement
approach to teaching behavioural finance and break 4 Markets are efficient Heuristics, frame
behavioural finance into two subtopics: and price will be dependence, emotions
Behavioural finance micro, and equal to intrinsic etc. will cause a
Behavioural finance macro value difference between price
and intrinsic value
Behavioural finance micro examines the 5 Price follow random Prices are pushed by
(BFMI) behavioral biases (that walk, though prices investors to
is, the irrational fluctuate they will be unsustainable levels in
behaviors) of brought back to both directions
individual investors. equilibrium position
Behavioural finance macro describes anomalies or The Pricing of Risk
Several models were suggested in traditional finance / using its earning power and the risk of its underlying
standard finance for the pricing of risk. The following assets and is independent of the way it finances
are the major ones. investments or distributes dividends. There are three
1. Modern Portfolio Theory methods a firm can choose to finance: borrowing,
2. Miller and Modigliani Theory spending profits (versus handing them out to
3. CAPM shareholders in the form of dividends), and straight
4. Arbitrage Pricing Theory issuance of shares. While complicated, the theorem in
5. Random Walk Hypothesis its simplest form is based on the idea that with certain
6. Expected Utility Theory assumptions in place, there is no difference between a
7. Efficient Market Hypothesis firm financing itself with debt or equity.
3. Capital Asset Pricing Model (CAPM)
1. Modern Portfolio Theory:MPT was postulated by It is proposed by Sharpe and Lintner in 1960. The
Harry Markowitz. MPT is based on the following Capital Asset Pricing Model (CAPM) is a model that
concepts. describes the relationship between expected return and
The expected return of a stock or portfolio and, risk of a security. It shows that the return on a security
The standard deviation and its correlation with is equal to the risk-free return plus a risk premium,
other stocks within a portfolio which is based on the beta of that security. CAPM is
The theory states that with the above concepts known, calculated according to the following formula:
it is possible to create an efficient portfolio for any Ra = Expected return Ra = Rrf + [Ba x (Rm – Rrf)]
group of stock. The efficient portfolio is the portfolio Where:
which maximises the returns and minimises the risk. on a security
The main premise of MPT is that risk is central to the Rrf = Risk-free rate
whole investment process and risky investments offer Ba = Beta of the security
higher returns so that the investor is compensated for Rm = Expected return on market
bearing the extra risk. The risk of a security is
measured in terms of variability of returns. When a Note: Risk Premium = (Rm – Rrf)
portfolio is formed with a combination of assets that It helps in determining the appropriate rate of return
provide the maximum expected return for different for an asset that is to be added to a diversified portfolio,
levels of risk and minimum risk for different levels of given the risk of that particular asset. The core idea of
expected returns, it becomes efficient. this model is that investors used to be compensated for
2. Miller and Modigliani Theory the time value of money and market specific risk. As
Modigliani and Miller, two professors in the 1950s, per CAPM, the difference in the expected returns of
studied capital-structure theory intensely. From their any two assets can be related to the difference in their
analysis, they developed the capital-structure betas. The higher the value of beta, higher would be
irrelevance proposition. Essentially, they hypothesized the risk of the security and the consequent expected
that in perfect markets, it does not matter what capital returns. The model states that the only important
structure a company uses to finance its operations. ingredient that determines expected returns is the
They theorized that the market value of a firm is systematic risk. 4. Arbitrage
determined by its earning power and by the risk of its Pricing Theory Proposed by
underlying assets, and that its value is independent of Ross in 1976. According to this theory, an attractive
the way it chooses to finance its investments or opportunity is created by irrational or noise traders
distribute dividends. The basic M&M proposition is through creation of mispriced securities. The rational
based on the following key assumptions: traders or arbitrageurs will be quick enough to grab the
opportunity and the mispricing created by the irrational
No taxes investors will be corrected. Though arbitrage does not
No transaction costs subscribe to the view that all investors are skilled and
No bankruptcy costs well-informed, in well – developed and liquid capital
Equivalence in borrowing costs for both markets, there are enough rational investors who
companies and investors ensure that the price of any security will be equal to its
Symmetry of market information, meaning fundamental value.Arbitrage pricing theory is an asset
companies and investors have the same pricing model based on the idea that an asset's returns
information can be predicted using the relationship between that
No effect of debt on a company's earnings asset and many common risk factors. Created in 1976
before interest and taxes by Stephen Ross, this theory predicts a relationship
between the returns of a portfolio and the returns of a
Of course, in the real world, there are taxes, transaction single asset through a linear combination of many
costs, bankruptcy costs, differences in borrowing costs, independent macroeconomic variables
information asymmetries and effects of debt on
earnings. The Modigliani-Miller theorem (M&M)
states that the market value of a company is calculated Where today's price is too low:
The implication is that at the end of the period the Basic assumptions of Random Walk Theory are as
portfolio would have appreciated at the rate implied by follows:
the APT, whereas the mispriced asset would have Markets are efficient and competitive with
appreciated at more than this rate. The arbitrageur impeccable communication
could therefore: Investors have full knowledge and information
Today: about the performance of any given company.
1 short sell the portfolio A change in stock price is triggered by
2 buy the mispriced asset with the information.
proceeds. All known information is reflected in prices.
At the end of the period: The returns on securities are independently
1 sell the mispriced asset and identically distributed random variables
2 use the proceeds to buy back the that have a finite variance.
portfolio 6. Expected Utility Theory
3 pocket the difference. The expected utility theory deals with the analysis of
situations where individuals must make a decision
Where today's price is too high: without knowing which outcomes may result from that
The implication is that at the end of the period decision, this is, decision making under uncertainty.
the portfolio would have appreciated at the These individuals will choose the act that will result in
rate implied by the APT, whereas the the highest expected utility, being this the sum of the
mispriced asset would have appreciated at less products of probability and utility over all possible
than this rate. The arbitrageur could therefore: outcomes. The decision made will also depend on the
Today: agent’s risk aversion and the utility of other agents.
short sell the mispriced asset The term expected utility was first introduced by
buy the portfolio with the proceeds. Daniel Bernoulli.
At the end of the period: According to Expected Utility Theory,
sell the portfolio When faced with various actions,
2 .use the proceeds to buy back the The result of each could give rise to more than
mispriced asset one possible outcome with different
pocket the difference probabilities
It is normal to rationally identify and
5. Random Walk Hypothesis determine the values of all possible outcomes
The random walk theory is the occurrence of an event and probabilities that will result from each
determined by a series of random movements - in other course of action
words, events that cannot be predicted. For example, multiply the two to get an expected value
one might consider a drunken person's path of walking after providing due weightage to the element
to be a random walk because the person is impaired of risk, the action that may give rise to the
and his walk would not follow any predictable path. highest total expected value would be chosen.
Applying the random walk theory to finance and According to Expected Utility Theory, investors are
stocks suggests that stock prices change randomly, completely rational
making it impossible to predict stock prices. The able to deal with complex situations
random walk theory corresponds to the belief that risk averse
markets are efficient, and that it is not possible to beat try to maximise wealth.
or predict the market because stock prices reflect all 7. Efficient Market Hypothesis
available information and the occurrence of new Efficient market hypothesis is proposed by Eugene
information is seemingly random as well. The random Fama in the year 1960. Efficient market is a market
walk theory is in direct opposition to technical analysis, where in there are large numbers of rational profit
which contends that a stock's future price can be maximisers actively competing with each other trying
forecasted based on historical information through to predict future market values of individual securities,
observing chart patterns and technical indicators. and where important current information is freely
Academics cannot conclusively prove or agree on available to all participants.
whether the stock market truly operates via a random Three arguments of EMH
walk or based on predictable trends because there are Investors are rational
published studies that support both sides of the issue. Careful account of all available information is
A follower of the random walk theory believes it's taken by everyone before making investment
impossible to outperform the market without assuming decisions.
additional risk. Critics of the theory, however, contend The decision maker always pursues his interest.
that stocks do maintain price trends over time – in Depending upon the information available, forms of
other words, that it is possible to outperform the market efficiency are of three types
market by carefully selecting entry and exit points for
equity investments.
Weak form of efficiency – deals with in the event of a loss than the happiness that he or she
information regarding the past sequence of may derive in case of a profit. This theory states that
security movements investors provide bigger weight to losses than the
Semi strong form of efficiency – deals with profits. This is, in a way, risk avoidance. According to
publicly available information this theory, investors tend to give a bigger weight to
Strong form of efficiency – deals with all their losses than to their gains, thus avoiding risks.
information, both public and private which However, according to Geva and Mintz (1997), an
includes even the insider information. investor normally tends to become a risk taker when he
or she incurs a loss. In addition to this, most investors,
The tests of the weak form hypothesis are essentially during the course of taking investment decisions,
tests of whether all information contained in historical exhibit certain behavioural biases, which often lead to
share prices of securities is fully reflected in the systematic errors. Prospect theory is designed to better
current prices. This hypothesis contradicts the describe, explain and predict the choices that the
statements of technical analysts who state that typical person makes especially in a world of
historical price movements can help the forecast the uncertainty.
future price trends and prices move in a predictable Characteristics of Prospect Theory
manner. Semi strong form of efficiency is tested by 1. Certainty – People have a strong preference to
checking whether all the publically available certainty and are willing to sacrifice income to achieve
information is fully reflected in the current stock prices. more certainty.
This hypothesis contradicts the statements of
fundamental analysts who state that analysis of 2. Loss aversion – People tend to give more weights
fundamental factors related to the company like to losses than gains. They are loss averse.
earnings, dividends, rights issues etc. can help the
forecast the future price trends and prices move in a 3. Relative positioning – People tend to be more
predictable manner. Strong form hypothesis are tests of interested in their relative gains and losses as opposed
whether all information, both public and private is to their final income and wealth. If your relative
fully reflected in security prices and whether any type position doesn’t improve, you feel better off.
of investor is not able to earn excess returns. The
strong form states two conditions to be met: first that 4. Small probabilities – People tend to under react to
successive price changes or returns are independent low probability events especially in case of losses. So
and second these successive price changes or return you may completely discount the probability of losing
changes are identically distributed, like Random Walk all your wealth if the probability is very small. This
theory. tendency can result in people making super risky
Challenges to Market Efficiency choices.
Cumulative Prospect Theory it is a model for
1. Small firm effect – Long term historical data have descriptive decisions under risk and crisis which was
suggested that small firm portfolios have always introduced by Amos Tversky and Daniel Kahneman in
helped the investors to gain higher returns compared to 1992 (Tversky, Kahneman, 1992). It is a further
large firm portfolios. This goes against the market development and variant of prospect theory. The
efficiency theory. difference between this version and the original
2. Monday effect (Weekend effect) – Across stock version of prospect theory is that weighting is applied
exchanges around the world, it was noticed that stock to the cumulative probability distribution function. The
prices tend to be lower on Monday and they keep on main observation of CPT (and its predecessor Prospect
rising till Friday. An investor who sells those stocks on Theory) is that people tend to think of possible
Friday can make around 13% returns, if he has bought outcomes usually relative to a certain reference point
the same on Monday. (often the status quo) rather than to the final status, a
3. Overreaction of market to new information – phenomenon which is called framing effect. Moreover,
Many at times it is noticed that the market overreacts they have different risk attitudes towards gains (i.e.
to news. For ‘good’ news supernormal profits can be outcomes above the reference point) and losses (i.e.
reaped in the market and for ‘bad’ news ‘abnormal’ outcomes below the reference point) and care
losses are witnessed by the market. generally more about potential losses than potential
gains (loss aversion). Finally, people tend to
4. Market timing ability of the fund managers – overweight extreme, but unlikely events, but
People tend to follow the advises given by the fund underweight "average" events. The last point is in
managers and when there is an advice to buy, herding contrast to Prospect Theory which assumes that people
tendencies push the market prices of those stocks in overweight unlikely events, independently of their
the upward direction. relative outcomes.
Prospect Theory
This theory was presented by Kahneman and Tversky MODULE 2– Perception, Memory and Heuristics –
(1979). As per this theory, investors feel more stressed Representatives and related biases – Irrationality and
Adaptation – Miscalibration – Other strains of 5. Selective perception – While indulging in
overconfidence – Brief history of rational thought – selective perception the perceiver tends to
Pascal – Femat to Friedman – Savage – Prerequisites ignore the finer details.
for rational choice and Quasi Rational Choice. 6. Primary effect – The error of perception is
Perception – The way in which something is regarded, based on the fact that the first impressions are
understood, or interpreted is perception. It is ‘the lasting impressions.
awareness of the elements of environment through 7. Recency effect – It is a perceptual error,
physical sensation’. The following are the few wherein the most recent information
variables in the process of perception. dominates one’s perception.
a. Inputs – Includes the objects, events, people etc. that 8. Inference – Perceiver draws conclusions
the perceiver receives through senses. without adequate information.
b. Process – The inputs received by the perceiver are 9. Self fulfilling prophecy – This occurs when
then processed. This processing takes place through the expectation about a situation or person
selection, organisation and interpretation. leads the perceiver to act in a way that is
c. Outputs – the feelings, actions, attitudes etc. derived consistent with the expectation.
through processing mechanism are known as output. 10. Projection bias - This error occurs when one
d. Behaviour – Any behaviour is based on perceived believes that other persons too have similar
outputs. beliefs and behaviours as that of the perceiver.
Factors affecting perception COGNITION, COGNITIVE BIASES,
• Internal factors COGNITIVE DISSONANCE
1. Needs and desires – Perception of any Cognition is defined as Bits of knowledge that pertain
individual is based on his or her needs and to any variety of thoughts, values and facts.
desires. COGNITIVE BIASES are classified into
2. Personality – Personality of individuals varies 1. Attentional Bias – Selective attention towards
substantially and it influences perception. threat related stimuli
3. Experience – Previous experience plays a 2. Interpretive Bias – Tendency of an individual
major role with respect to perception. to interpret ambigious stimuli in a threatening
• External Factors way
1. Size – Larger the size of an object or stimuli, 3. Explicit memory Bias – Tendency to retrieve
higher the chances of being perceived. negative or unpleasant information than
2. Intensity – As in the case of size, higher the positive information. This bias may be
intensity of a stimuli, better the chances of depended on conscious recollection
being noticed. 4. Implicit Memory Bias – Tendency to have
3. Frequency – A repeated stimulus stands the better memory performance for relative
chance of being attracted and selected over an negative information; Not involving conscious
occasional one. recollection
4. Status – The status of the person being COGNITIVE DISSONANCE
perceived exerts considerable influence on It is defined as the inconsistency in thoughts and
perception. actions. Dissonance gets in the way of finding some
5. Contrast – stimuli that contrast sharply with truth. If we want to understand the world, we want a
the environment stands a better chance of clear, consistent picture of it.Anything which is
being noticed. inconsistent is a problem and we are motivated to
Errors in Perception restore consistency again.
1. Halo effect – Process of drawing of general Cognitive dissonance can be overcome in the
impressions or concision about an individual following manner.
based on a single characteristic / trait is known 1. You change one of your thoughts
as halo effect. 2. Change your behaviour
2. Stereo typing – Judging a conclusion about a 3. Add a thought to rationalise
person based on the perception of the group to 4. Trivialise the inconsistency
which he or she belongs to is stereotyping. MEMORY
3. Attribution – Is defined as the process that an Memory is the faculty of the brain by which
observer uses to infer the causes of another’s information is encoded (process often known as
behaviour. Learning), stored, and retrieved when needed. Memory
4. Impression – Everybody forms impressions is reconstructive and varies intensity. Reconstructive
about other people without having any memory - the act of remembering is influenced by
knowledge about the characteristics or traits of various other cognitive processes
the individual. This may lead to perceptual including perception, imagination, semantic
errors. memory and beliefs, amongst others
HEURISTICS
A heuristic is a mental shortcut that allows people to heuristic shows how "bias of availability is related to
solve problems and make judgments quickly and the ease of recall.
efficiently. These rule-of-thumb strategies shorten Ambiguity Aversion
decision-making time and allow people to function Ambiguity aversion (also known as uncertainty
without constantly stopping to think about their next aversion) is a preference for known risks over
course of action. Heuristics are helpful in many unknown risks. An ambiguity-averse individual would
situations, but they can also lead to cognitive biases. rather choose an alternative where the probability
Why Do We Use Heuristics?Psychologists have distribution of the outcomes is known over one where
suggested a few different theories: the probabilities are unknown. This behavior was first
introduced through the Ellsberg paradox (people prefer
Effort reduction: According to this theory, to bet on the outcome of an urn with 50 red and 50
people utilize heuristics as a type of cognitive blue balls rather than to bet on one with 100 total balls
laziness. Heuristics reduce the mental effort but for which the number of blue or red balls is
required to make choices and decisions. unknown).
Attribute substitution: Other theories suggest Diversification Heuristics
people substitute simpler but related questions People seek more variety when they choose multiple
in place of more complex and difficult items for future consumption simultaneously than
questions. when they make choices sequentially, i.e. on an ‘in the
Fast and frugal: Still other theories argue that moment’ basis. Diversification is non-optimal when
heuristics are actually more accurate than they people overestimate their need for diversity.
are biased. In other words, we use heuristics Status Quo Bias and Endowment Effect
because they are fast and usually correct. Status quo bias is an emotional bias; a preference for
the current state of affairs. Status quo bias has been
Heuristics play important roles in both problem- attributed to a combination of loss aversion and
solving and decision-making. When we are trying to the endowment effect, two ideas relevant to prospect
solve a problem or make a decision, we often turn to theory. An individual weighs the potential losses of
these mental shortcuts when we need a quick switching from the status quo more heavily than the
solution.The world is full of information, yet our potential gains
brains are only capable of processing a certain amount. Endowment Effect
If you tried to analyze every single aspect of every The endowment effect (also known as divestiture
situation or decision, you would never get anything aversion and related to the mere ownership
done.In order to cope with the tremendous amount of effect in social psychology) is the hypothesis that
information we encounter and to speed up the people assign more value to things merely because
decision-making process, the brain relies on these they own them.
mental strategies to simplify things so we don't have to Representativeness and related biases
spend endless amounts of time analyzing every detail. The representativeness heuristic is simply described as
BOUNDED RATIONALITY MODEL assessing similarity of objects and organizing them
It was proposed by Simon in the 1950s. Also termed as based around the category prototype (e.g., like goes
the ‘Administrative Man Model’, this theory fetched with like, and causes and effects should resemble each
him a Nobel Prize in 1978. The model elucidates the other). This heuristic is used because it is an easy
behavioural concepts that underlie economic decision computation.
making. According to bounded rationality, decision Related biases of Representativeness
makers are limited by constraints. Some of them • Ignorance of base rates -
include aspects like values, unconscious reflexes, skills • Conjunction fallacy
and habits. Further it is also assumed that human • Ignorance of sample size
rationality has certain inherent limitations, particularly • Dilution effect
when it is operating in substantial risk and uncertainty • Misperception of randomness
situations. In such situations decision makers force Anchoring
themselves to be less than completely rational and Anchoring or focalism is a cognitive bias for an
settle for much lower levels. In the other sense, they individual to rely too heavily on an initial piece of
seek a kind of bounded or limited rationality while information offered (known as the "anchor") when
making decisions. making decisions. Anchoring and adjustment is a
DIFFERENT TYPES OF HEURISTICS heuristic used in many situations where people
Familiarity and Related Heuristics:The familiarity estimate a number. People did not shift far enough
heuristic stems from the availability heuristic, which away from the anchor. Hence the anchor contaminates
was studied by Tversky and Kahneman. The the estimate, even if it is clearly irrelevant.
availability heuristic suggests that the likelihood of Availability (Recency and Salience)
events is estimated based on how many examples of Availability Heuristics – events that are called to mind
such events come to mind. Thus the familiarity easily are believed to have a greater likelihood of
occurring. Two factors abet availability – Recency &
Salience. Salience could get influenced by egocentric Module3– Investor Behaviour: Financial Behaviour
judgments. Recency effect - The Recency Effect is the stemming from Familiarity, Financial Behaviour
finish. You remember the end the best. stemming from Representativeness-Over confidence
Gambler’s Fallacy and Excessive Trading- Under diversification and
The gambler's fallacy, also known as the Monte Carlo Excessive Risk Taking- Investor Decision cycle-
fallacy or the fallacy of the maturity of chances, is the Decision making under risk and uncertainty-Expected
mistaken belief that, if something happens more utility theory- Decision making in Historical
frequently than normal during a given period, it will prospective-Allais and Elsberg’s paradoxes-Errors in
happen less frequently in the future (or vice versa). Decision making.
OVERCONFIDENCE 1. Explain Financial behaviour stemming from
Is the tendency for people to overestimate their Familiarity:The familiarity heuristic stems from
knowledge, abilities and the precision of their the availability heuristic, which was studied
information, or to be overly sanguine of the future and by Tversky and Kahneman. The availability heuristic
their ability to control it. suggests that the likelihood of events is estimated
Overconfidence can be measured in different ways – based on how many examples of such events come to
one among it is miscalibration. mind. Thus the familiarity heuristic shows how "bias
Miscalibration is the tendency for people to of availability is related to the ease of recall.
overestimate the precision of their knowledge. The following are different types of financial
OTHER STRAINS OF OVER CONFIDENCE behaviour as a result of ‘Familiarity Heiristics’.
• Better than average effect - Individuals Home Bias – Tendency to overinvest domestically and
evaluating themselves as above average in a locally. Related to home bias is the tendency to invest
self-serving manner in companies you work for or brands you know.
• Illusion of control - The illusion of control is People tend to concentrate in home country with
the tendency for people to overestimate their respect to their investments. This could be because of
ability to control events the following reasons (a) Preference for familiarity of
• Excessive optimism – It is a cognitive bias that language and culture (b) Local investing and
causes a person to believe that they are at a informational advantages (c) Invest more in a stock on
lesser risk of experiencing a negative event which you have more precise information.
compared to others. Tendency to overestimate predictability induces
BRIEF HISTORY OF RATIONAL THOUGHT investors to believe that good companies are good
Rationality is the quality or state of being rational – investments.
that is, being based on or agreeable Recency effect – People believe that good recent stock
to reason Rationality implies the conformity of one's market performers are good buys.
beliefs with one's reasons to believe, and of one's Availability bias – Pushes people to concentrate on
actions with one's reasons for action. investments in securities on which information is
The conceptual development of a current‐day freely available.
comprehension of “rationality” by using four 2. Explain Financial behaviour stemming from
episodes: Representativeness
Ancient thinking towards wise leadership; The representativeness heuristic is simply described as
The Greek idea of logos; assessing similarity of objects and organizing them
The nineteenth century modernist belief in based around the category prototype (e.g., like goes
positivism; with like, and causes and effects should resemble each
And the twentieth century “postmodernist” other). This heuristic is used because it is an easy
debate computation.
QUASI RATIONAL CHOICE The following are some of the investor behaviour
Imagine that you purchased a ticket to a concert given which come from ‘Representativeness Heuristics’
by your favourite musical group. On the evening of the • Overestimating the predictability - Also
concert, a blizzard makes travel extremely hazardous. known as Hindsight bias, also known as
Would you go? Now imagine that you had been given the knew-it-all-along effect . It is the
this same ticket. Would you be more or less likely to behaviour shown by an individual, after an
travel to the concert in this case than in the previous event has occurred, to see the event as having
case?if you are like most people, you would be less been predictable, despite there having been
likely to go to the concert if the ticket were given to little or no objective basis for predicting it
you. However, this response is, according to the logic • Chasing winners (Recency effect) - An
of economics, irrational.There are cases in which investor suffering from recency bias would
people deviate from the behavior that the simple most likely make their investment decisions
calculus of utility maximization says they should solely based on the past 1-3-year performance.
follow, and these deviations are predictable. Richard This behavior has come to be known as
Thaler said that this behaviour was "quasi-rational”. “strategy chasing,” and often resembles a
counterintuitive practice of buying high and • Analysts tend to be overly optimistic about the
selling low. prospects of the companies they follow
• Trend following / Momentum chasing - (Excessive risk taking)
Instead of identifying the continuation or 5. Explain the influence of emotions on investor
reversal pattern, momentum investors focus on behaviour.
the trend created by the most recent price While we cannot understand every factor that
break. Momentum investors like affects decision- making, some emotions have
to chase performance. They attempt to achieve proven to be useful in understanding the
alpha returns by investing in stocks financial choices people make. The following
that trend one way or another. are a few among them
• Momentum chasers vs. Contrarians - While • Regret, Pride and Anger – Regret is a
momentum investing is a method that attempts negative emotion. You might regret a bad
to take advantage of the most recent market investment decision and wish you had made a
trends, contrarian investing takes the opposite different choice. Pride is the flip side of regret.
approach.Market contrarians invest on the People tend to project if they have earned
premise that the most recent market conditions profit during the trade. The effects of pride and
aren't realistic, and therefore they make regret are asymmetric. People are more
investment decisions that deviate from the motivated to avoid the feeling of regret than
general direction of the markets. getting a feeling of pride.
• Availability and attention grabbling - • Disposition effect – Researchers have
Attention-grabbing remark or activity is one recognized the tendency of investors to sell
that is intended to make people notice. This superior – performing stocks too early while
could be made possible by spreading the holding onto losers. This is called disposition
awareness or information on investment effect. It happens because investors will have a
options / assets. Availability of information feeling that the losers will bounce back.
will grab attention of the investors. • House money effect- This is the tendency of
• Anchoring to available cues – Another an investor to assume more risk if he has
behavioural pattern which stems from achieved a profit or gain earlier. This is
Representativeness Heuristics is the anchoring normally seen in gambling or casinos.
effect. People tend to anchor their decisions on • Snake bit effect- An initial loss can increase
the available figures and numbers, instead of the risk aversion of a person and it is called
searching for the complete information. snake bit effect
• Herding effect - – herd mentality is • Trying to break even effect – Sometimes
characterised by a lack of individual decision person with a prior loss may take a risky
making or thoughtfulness, causing people to gamble in order to try to break even.
think and act in the same way as majority of 6. Explain the term ‘Mental Accounting’.
those around them. Small investors keep Mental accounting refers to the way people categorize
watching participants for confirmation and money. According to mental accounting, people place
then end up entering the market when the value based on which category the money falls into.
markets are overheated and poised for Some categories are worth more than other categories.
corrections. This can sometimes go against logic.
3. Explain the term ‘Overconfidence’ in the context You are taking a break from work and are at the local
of financial behaviour. hamburger joint. You are about to purchase your
• Is the tendency for people to overestimate their favourite bacon cheeseburger with fries combo meal
knowledge, abilities and the precision of their for $8. As you get ready to pay for your meal, however,
information, or to be overly sanguine of the you notice that you are short by $8 in your wallet.
future and their ability to control it. Thinking back, you realize that you might have lost
• Overconfidence can be measured in different that money when you were jogging this morning. You
ways – one among it is miscalibration. think about it, and you decide to purchase your meal.
• Miscalibration is the tendency for people to The $8 was lost, and there's nothing you can do about
overestimate the precision of their knowledge. it.
4. What are the common traps for an overconfident Now, what if, after purchasing your cheeseburger and
investor? fries combo meal, you trip and your food ends up all
• Excessive trading (Thrill seeking, Experience over the floor. Would you go ahead and purchase
seeking, Disinhibition, Boredom another cheeseburger and fries combo meal?
susceptibility) Traditional economics says that you would react in the
• Under diversification – overconfident same manner in both scenarios since you have lost the
investors will be reluctant to diversify same amount of money, $8. But surprisingly, research
shows that more people, 88 percent actually, end up
buying when the money is lost, and only 46 percent
buy when they have to replace a lost item that has
already been purchased.
7. Explain the different manifestations of the same.
• Investors have a tendency to ride the losers as
they are reluctant to realize losses. Mentally
they treat unrealized “paper loss” and realized
“loss” differently.
• Investors often integrate the sale of losers so
that the feeling of regret is confined to one
time period
• Investors tend to stagger the sale of winners
over time to prolong the favourable experience.
• People are more venturesome with money
received as bonus, but very conservative with
money set aside for children’s education.
• Irrational preference for stocks paying high
dividends (they don’t mind spending the
dividend income), but do not prefer to sell a
few shares and spend the capital.
8. Define ‘Expected utility theory’
The expected utility theory deals with the analysis of
situations where individuals must make a decision
without knowing which outcomes may result from that
decision, this is, decision making under uncertainty.
These individuals will choose the act that will result in
the highest expected utility, being this the sum of the
products of probability and utility over all possible
outcomes. The decision made will also depend on the
agent’s risk aversion and the utility of other agents.
Expected Utility = p1*u1 + p2*u2 + … + pn*un.
p: probability of an event
u: utility derived from the event
9. Explain Allais paradox
Allias paradox is an inconsistency which you can see
in the case of Expected Utility Theory.
This paradox relies in the fact that in certain types of
gambling, although people usually prefer certainty
to uncertainty, if they are approached differently, they
will prefer the uncertainty that was previously
rejected.
10. Explain Elsberg’s paradoxes
The Ellsberg paradox is a paradox in decision
theory in which people's choices violate the postulates
of subjective expected utility. It is generally taken to
be evidence for ambiguity aversion. People will
always choose a known probability of winning over an
unknown probability of winning even if the known
probability is low and the unknown probability could
be a guarantee of winning.
That is, given a choice of risks to take (such as bets),
people "prefer the devil they know" rather than
assuming a risk where odds are difficult or impossible
to calculate.
6. Explain Investor Decision Cycle and various
emotions attached to market cycles.
Module-4 – Corporate Finance: Mispricing and Goals b). Disposition effect is a behavioural flaw which tend
of Managers- Irrational Managers or Irrational to influence the abandonment of loss making projects
Investors. Investor psychology-Forecasting Bias- by the managers. Managers tend to continue loss
Emotional Decision Making- Errors in Decision making projects, on the hope that things will
making- Behavioural corporate finance and eventually turn around. It is seen that the abandonment
Managerial decision making- Investing style and of loss making projects are well received by the market,
Behaviour Finance. rather than continuing the same.
1. Why behavioural finance matters in corporate c). Overconfidence of managers can lead to
finance setting? overinvestment in projects which will eventually lead
Behavioural factors may matter for two reasons (1) to unutilised idle capital. Overconfidence of the
Managers, like investors and other financial market managers will also result in ignoring a project’s
participants appear to sometimes act in a less than fully sensitivity to cashflows. Overconfident manager tends
rational fashion due to cognitive limitations, to overestimate the returns from their projects.
overconfidence and force of emotions. (2) Rational Overconfident managers tend to be more active in
managers may at times take advantage of the valuation merger and acquisition front without assessing the
mistakes made by irrational investors. market factors.
2. What are the examples of managerial actions 5. Explain the psychographic models which can be
taking advantage of mispricing (caused by used to explain investor psychology?
irrational investors)? a) Barnewell Two Way Model
Managers can take advantage of mispricing by One of the oldest and most popular psychographic
a. Changing the company name – A strategy at models was developed by M.M. Barnewell to improve
negligible cost is to change the company name to the interface of investment advisors with clients. He
something with greater appeal to investors. During the made a distinction between two relatively simple
internet crazy period in late 1990s there were many investor types viz, passive investors and active
companies that changed their names to “dotcom”. investors.
These firms saw their shares appreciate, even when Passive Investor – (1) Passive investors have lesser
their underlying business had little or nothing to do tolerance for risk and greater need and security (2) The
with internet. smaller the economic resources of the person, the
2. Explaining dividend patterns – In a world of perfect greater the likelihood that the person will be a passive
market, payment of dividends could be irrelevant. But investor (3) Certain occupational groups tend to be
in the real world it is much more complicated. passive investors (4) A large proportion of the middle
Managers use dividends are catering tools. and lower socio – economic classes are passive
3. Share Issues and repurchases – When shares are investor
overvalued, current long run shareholders benefit when Active Investor – (1) Active investors have a high
management issues shares. Conversly, when shares are tolerance for risk and lesser need for security (2)
undervalued, long run shareholders benefit when Active investors prefer to control their investments (3)
managers repurchase stock. By their active involvement, they believe that they can
4. Mergers and Acquisitions – Cash acquisitions make reduce risk to an acceptable level
sense when undervalued assets can be acquired. The b) Bailard, Biehl and Kaiser (BB&K) Five way
hostility of target management in such cases serves the model
interests of their own shareholders. • BB&K classify investor personalities along
3. Explain the term ‘mispricing’ two dimensions viz., level of confidence and
The definition of a mispricing is something that has method of action.
the wrong price on it. Mispricing could lead to • The first aspect of personality deals with how
underpricing or overpricing of shares. confidently investor approaches life (approach
4. How do behavioural mistakes (flaws) of to his career, health and his money).
managers (irrational managers) impact capital • The second element deals with whether the
budgeting decisions in corporate finance scenario? investor is methodical, careful and analytical
The following are the prominent errors which may in his approach or whether he is emotional,
influence capital budgeting decisions as a result of intuitive and impetuous.
behavioural flaws of the managers. • Two axis – “Confident – anxious axis” &
a). Due to ease of processing, Pay Back Period is “Careful – impetuous axis”
often used to evaluate the capital budgeting decisions BB&K Five Way Model provides the following five
rather than using more scientific techniques like Net investor personality types.
Present Value or IRR. The desirability to get your 1. The Individualist - An individualist tends to go
money back quickly is a clear concept even to a not so his own way and is typified by an independent
knowledgeable person. Psychology is playing a role professional or the small business person.
here in choosing a less sophisticated method like Pay Quite confident, an individual decides, in a
Back Period, due to its ease of processing. careful, methodical and analytical manner.
Since he is rational, the investment counsel Module-5 – Anomaly Attenuation-style peer Groups
can communicate well with him. and style investing- Multivariate approach-Style
2. The Adventurer - A very confident person, the rotation-Neurofinance and the trader’s Brain-
adventurer, is willing to place huge bets. Since Expertise and Implicit learning- Expertise and
he has his own ideas about investing, it is Emotion- Gender, Personality Type, and Investor
difficult to advise him. From the point of view Behaviour- Investor Personality Types-
of the investment counsel, the adventurer is a Neuroeconomics- rational Managers and Irrational
volatile client. investors
3. The Celebrity - The celebrity prefers to be 1. Explain the term “anomaly attenuation”
where the action is and does not want to be left A number of anomalies (irregularities) once reported
out. Although he may have his own ideas in the market, either attenuated or fully disappeared
about other things in life, in the realm of over a period of time. A number of research papers
investing he does not have his own ideas. So have also documented a decline in the anomaly profits
he is perhaps the best prey for maximum in recent years. This could be because of the changes
broker turnover. in trading technologies and liquidity in the financial
4. The Guardian - The guardian is careful and a markets.
bit concerned about money. When people get 2. What is an example of an anomaly that once
older and when they reach their retirement age, reported in research studies has attenuated? Is this
they approach this personality type. The positive or negative from the stand point of market
guardian focuses on preserving his assets. He efficiency?
is not interested in volatility or excitement. Most of the financial anomalies have attenuated. A few
5. The Straight Arrow - A straight arrow is well examples are the small firm effect, the January effect,
balanced. Since he cannot be placed in any the weekend effect etc. The intensity of the anomaly
specific quadrant, he falls near the centre. He impact has significantly reduced and this is negative
is a relatively balanced composite of the four from the standpoint of the market efficiency. As we
different investor types and is willing to be know, anomalies go against the assumptions of the
exposed to moderate amounts of risk. efficient market hypothesis and so if the intensity
6. What do you mean by forecasting bias? reduces, it means the anomaly is headed towards the
A forecast bias occurs when there are consistent provisions of the EMH as outlined by Fama (1970).
differences between actual outcomes and previously 3. Explain the following terms
generated forecasts of those quantities; that is: a. Style Peer Groups
forecasts may have a general tendency to be too high Portfolio managers are commonly evaluated based on
or too low. A normal property of a good forecast is their style. Style is usually defined in terms of firm
that it is not biased. size and growth v/s value. Portfolio managers are
7. Will emotions affect decision making? divided into nine groups based on three by three matrix,
Behaviour is different from emotions but is very where size changes from small – cap to mid – cap to
strongly influenced by them. One way large – cap, and value v/s growth ranges from value to
that behaviour is affected by emotions is through blend to growth.
motivation, which drives a person's behaviour. When a If a manager tilts towards small cap value (because
person feels frustration, anger, tension or fear, they are small cap value has performed well in the past) she
more likely to act aggressively towards others. will be compared against other managers doing the
8. Explain the techniques which can be used to exact same thing (Style followed by the peer group).
overcome psychological biases. b. Style Investing
• Understand the biases Style investing is the study of asset prices in an
• Focus on the big picture economy where some investors classify risky assets
• Rely on words and numbers, not sights and into different styles and move funds back and forth
sounds between these styles depending on their relative
• Follow a set of quantitative investment criteria performance. Style investing is an investment
• Diversify approach in which rotation among different "styles" is
• Take care of the downside supposed to be important for successful investing. As
• Control your investment environment opposed to investing in individual securities, style
• Strive to earn market returns investors can decide to make portfolio allocation
• Track your feelings decisions by placing their money in broad categories of
• Review your biases periodically assets, such as "large-cap", "growth", "international",
• Rebalance or "emerging markets".
c. Style Tilting
A portfolio “tilt” is industry slang for an investment
strategy that overweighs a particular
investment style. An example would be tilting to
small-cap stocks or value stocks that have historically The three dimensions of personality types are idealist
delivered higher returns than the stock market. versus pragmatist, framer versus integrator and
d. Style rotation reflector versus realist.
This is the notion that there exist predictability in the Individual who fit into the idealists can be the theme
relative performance of "box style" portfolios, i.e. to the subsequent biases: overconfidence, optimism,
those portfolios characterized by the factors of size availability, illusion of control, confirmation, recency
(small cap, mid cap, large cap) and growth vs. value and representativeness. Pragmatists being an investor
(value, blend, growth). are classically not prone to the abovementioned biases.
4. Explain the role of neuro finance in describing a While in second dimension, framers may be subject to
trader’s brain these biases: anchoring, conservatism, mental
profesional securities traders experience emotional accounting, framing and ambiguity. Integrators don’t
states characterized by hugh have aforesaid biases of framers.
arousal market events such as high price volatility, In third dimension, reflectors prone to the following
using peripheral measures of arousal, like skin biases: cognitive dissonance, loss aversion,
conductance and blood volume pulse. endowment, self-control, regret, status quo and
profesional securities traders experience emotional hindsight but realists do not prone to biases of
states characterized by hugh reflectors. Pragmatist, integrator and realist thinking
arousal market events such as high price volatility, are opposite to the idealist, framer and reflector
using peripheral measures of arousal, like skin B) SECOND PERSONALITY TYPE MODEL
conductance and blood volume pulse. SUGGESTED BY MYERS & BRIGGS
Neurofinance is one of the sub-fields in the area of 1. Rational(NT)- Attribute to the technical results.
Behavioural Finance research. It’s the area which They sell and buy according to Financial statements
focuses on how out brain works. In neurofinance, we and financial ratios; therefore, their strength in making
examine experimentally the nature of the cognitive quick decision reduces.
processes engaged in acquiring and processing 2. Guardian(SJ) They trust consistent and clear
information in financial decision making. information that is available, such as: profitability
To achieve this there are two types of actions. ratios. They make a better decision in stocks that have
Look at behaviour obvious tends.
Scan the brain of the subjects during the 3. Idealist(NF) They do not interest to work as a direct
experiment investor in stock exchange and if they participate, they
prefer to keep stocks.
When this was done in the case of traders, researchers 4. Artisan (SP) Interested in executives opinions,
could understand a lot of behavioural factors. The two gossip and shareholders They are risky and prefer to
prominent points which they have noted are as follows: earn profits from the volatility.
a. Greed actually turns off the fear centres in the brain. GENDER AND INVESTOR BEHAVIOUR
This will eventually lead to risk taking behaviours by Women are more conservative while investing and are
the traders. unwilling to take risk. Thus women should be offered
b. We are naturally inclined to want to “do something” such financial products which are best suited for them
in times of stress. It gives us specific action items to do in terms of risk and return characteristics. Males are
so that our natural instincts – which rarely work in our more overconfident than females with respect to risk
favour when trading. This is what most of the traders taking in investment. Men have a stronger tendency
do when they are exposed to stress. towards overconfident behaviour than women.
5. Differentiate ‘Expertise’ and ‘Implicit Learning’. 6. Explain the process of de-biasing
Expertise is special skill or knowledge that is acquired Some steps to eliminate bias
by training, study, or practice. Expertise in investing or 1. Awareness of bias
trading can be research expertise or pattern recognition 2. Motivation to eliminate bias
expertise. 3. Direction and magnitude on awareness of bias
Implicit learning is the learning of complex 4. Ability to eliminate bias
information in an incidental manner, without
awareness of what has been learned. Example – But the steps taken to reduce / eliminate bias will
learning of language acquisition and learning the depend upon the personality of individuals.
process of socialization. For individuals who belong to ‘Perfectible judges’
6. Explain the role of gender and personality type category, debiasing can be done through
on investor behaviour. 1. Warn of the problem
PERSONALITY TYPES AND INVESTOR 2. Describe problem
BEHAVIOUR 3. Provide personalized feedback
A) FIRST PERSONALITY TYPE MODEL 4. Train extensively
SUGGECTED BY POMPIAN
For individuals who belong to ‘Incorrigible Judges’,
debiasing can be done through
1. Replace them
2. Recalibrate their responses
3. Build error into your planning
7. Explain the different secretions of brain and how
they influence investment behaviour.
Role of Dopamine
Dopamine is a chemical secreted in brain at the time
of a feeling of pleasure. More quantity of dopamine is
secreted at the time of unexpected profits earned easily.
At the same time when investors face an unexpected
loss, the secretion of dopamine completely stops, and
the person feels depressed.
Dopamine is responsible for behavioural biases like
Herd Behaviour, Overconfidence and Optimism in the
investors.
Role of Serotonin
Serotonin is a transmitter available in central nervous
system and digestive tract. Serotonin is responsible for
the feelings of anxiety, depression and appetite.
Reduced levels of serotonin cause investors to sell
winning positions too early. Loss Aversion may be a
result of reduced levels of serotonin.
“Take the money and run” is the tendency developed
because of reduced supply of serotonin.
8. Explain the different parts of brain which play a
crucial role in investment behaviour.
a. Role of Amygdala
Almond shaped body situated in brain’s temporal
medial lobe is responsible for feeling of emotions like
fear, pleasure, developing phobia and post traumatic
stress. Amygdala is responsible for “fight or flight”
behaviour of investors. Selling behavior of investors
in falling markets are due to functioning of amygdale.
Investors want to flight away from the falling markets
because of the feeling of fear, but actually it is the time
to fight with the bear phase and add some
fundamentally strong stocks at corrected value.
b. Role of Prefrontal Cortex
The prefrontal cortex of brain is responsible of
complex cognitive decision making in social behaviour
and expression of personality. Whenever investors
commit cognitive errors, it means that prefrontal cortex
does not have proper data in form of accurate,
appropriate and update information for drawing
decisions.
c. Role of Nucleus Accumbens and Anterior
Cingulate
Nucleus Accumbens is a group of neurons located
behind the ears of a human being. This group of
neurons plays a role in developing addictive behaviour.
Anterior Cingulate, which is the frontal portion of
cingulated cortex plays important role in reward
anticipation and decision making.
Together, the Nucleus Accumbens and anterior
cingulated help people to identify patterns and evaluate
alternatives.