Behavioral Finance

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Behavioral Finance
Pankaj Mathpal
CFPCM, CWM, CIWM, CPFA
Contents
Introduction to Behavioral Finance Efficient Market Hypothesis Utility Preference Theory Pascal-Fermat to Friedman-Savage Paradoxes
Pankaj Mathpal, CFP, CWM, CIWM, CPFA
What is behavioral finance..?

It is an integration of classical economics and finance with psychology and the decision-making sciences. It is an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature. It is the study of how investors systematically make errors in judgment , or mental mistakes.
Efficient market hypothesis (EMH):
Introduced by Markowitz in 1952. Names by FAMA in 1970. Assumes that financial markets incorporate all public information and asserts that share prices reflect all relevant information.
EMH frequently includes assumptions such as

Transaction costs are zero Markets are not segmented Easy entry into the security markets exists
The EMH rest on the 3 assumptions: 1.Market actors are perfectly rational and are able to value securities rationally. 2.Even if there are some investors who are not rational, their trading activities will either cancel out with one another or will be arbitraged away by rational investors. 3.Market actors have well defined subjective utility functions which they will maximize.
Limits of the efficient market hypothesis:

The bounded rationality
Investors tend to deviate from rationality because of their attitude towards risk and to their sensitivity to decision making
The limited arbitrage

If irrational traders cause deviations from fundamental value, rational traders will ofetn be powerless
Isolation Effect Lottery 1- Rs. 1000, 5% and 0, 95% Lottery 2- Rs. 100, 50% and 0, 50%
Certainty Effect Lottery- 1 A) A sure gain of Rs. 1000 B) 80% chances to gain Rs. 1500 and 20% to win nothing Lottery-2 C) 25% chances to win Rs. 1000 and 75% to win nothing D) 20% chances to win 1500 and 80% chances to win nothing
Utility preference theory

Traditional finance is based on utility theory, which in turn assumes individuals base decision on all available information, including past price and volume data as well as firms, market and investment specific information.
Brief history of rational thought:

Brief History of rational thought: Pascal- Fermat to Friedman-savagef rational During the last century two paradigms competed for general acceptance: The rational paradigm "here investors are rational and optimize their utility function in order to make decisions, markets are efficient, and each investor needs one optimal portfolio The behavioral paradigm "here investor behavior displays important biases compared to the rational behavior, utility is relative to a reference point and can display concave and convex areas and therefore investors do not have one efficient portfolio but have fragmented portfolios, markets are not efficient.
Struggle between the two paradigm was most pronounced in 20th century. Now its widely accepted that investor display important deviation from rational behavior.
Expected Utility Theory

Expected utility theory is based on axioms hypothesising a rational behaviour Does not aim to describe the reality but to set up a framework for evaluating the rationality of ones behaviour
Only money matters and more money is not worse than less money under uncertainty, there is a difference between a good and a lucky decision According to Howard,
a lucky decision is a future state of the world that we prize relative to other outcomes; in contrast, a good decision is an action we take that is logically consistent with the alternatives we perceive, the information we have, and the preferences we feel.
Quiz
Consider a choice as a combination of two lotteries:
First choice: Lottery A or Lottery B
Lottery A- Sure gain of Rs. 2,400 Lottery B- 25% chance of a Rs.10,000 gain and a 75% chance of 0 gain
Then choose: Lottery C or Lottery D

Lottery C- Sure loss of Rs. 7,500 Lottery D- 75% chance of a Rs. 10,000 loss and a 25% chance of 0 loss
First choice: Let us assume that investments A and B have the following outcomes:
Portfolio A: 5,000 with certainty Portfolio B: 10,000 with probability 0.5, 0 with probability 0.5
Second choice: Portfolio C and D with following outcome

Portfolio C: -4,900 with certainty Portfolio D: -10,000 with probability 0.5, 0 with probability 0.5
There is a fair dice with outcomes from 1 to 6 (with the same probability). Consider the two schemes A and B available with the payoffs:
There is a fair dice with outcomes from 1 to 6 (with the same probability). Consider the two schemes A and B available with the payoffs:
Dice outcome
1 Rs.600 Rs.500
2 Rs.700 Rs.600
3 Rs.800 Rs.700
4 Rs. 900 Rs. 800
5 Rs. 1000 Rs. 900
6 Rs. 500 Rs. 1000
Scheme A Scheme B
Paradoxes: The Allais paradox is a choice problem designed by Maurice Allais to show an inconsistency of actual observed choices with the predictions of expected utility theory. The Allais paradox highlights the fact that the independence axiom is often no longer respected if we take lotteries for which the outcomes have probabilities close to certainty (i.e. 100 percent) or impossibility (0 percent). People always prefer precise information to vague information.
St. Petersburg paradox: It is a paradox related to probability theory and decision theory.
The prospect theory: Has been developed in 1979 by the psychologists Daniel Kahneman and Amos Tversky who illustrated how investors systematically violate the utility theory.
Introduction: A heuristic is a strategy that can be applied to a variety of problems and that usually-but not always-yields a correct solution. People often use heuristics that reduce complex problem solving to more simple judgmental operations. There are different types of heuristics and biases by investors when making decisions under uncertainty.
Anchoring and adjustment:

It is a psychological heuristic that influences the way people intuit probabilities. People place undue emphasis on statically arbitrary, psychologically determined anchor points. Decision making therefore deviates from neoclassical prescribed rational norms.
The investors would normally exhibit anchoring adjustment heuristic in one of the following ways:
Investor tend to make general market forecasts that are too close to current levels. Investors tend to stick to their original estimates when new information is learned about a company. Investors tend to make a forecast of the percentage that a particular asset class might rise or fall based on the current levels of returns.
Mitigation of Biasness
Be a powerful asset when negotiating. It is wise to start with an offer much less generous than reflects your actual position. Awareness is the best counter measure to anchoring and adjustment bias.
Availability Heuristics
It is a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives.
Four out of several categories of availability bias that apply to most of investors.
Retrievable Categorization Narrow range of experience Resonance
Mitigation of Biasness
Investors should be made aware about research and contemplate investment decision before executing them. Focus on long term trends.
Representativeness heuristic
in order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts.
Two primary interpretation of representative bias apply to the individual investors

Base rate Neglect Sample Size Neglect
Regret aversion: this bias seeks to forestall the pain of regret associated with poor decision making. Nave diversification: - In light of importance and prevalence of risky allocation, there should be great interest in understanding how people make such decisions and how they might be improved. - In a groundbreaking investigation of personal savings decisions in which behavioral theorists have argued that people typically employ nave diversification strategies, allocating 1/n of their funds in each of n investment prospects available to them
Mental accounting bias: it describes peoples tendency to code, categorize, and evaluate economic outcomes by grouping their assets into any number of no fungible mental accounts. Framing bias: Framing bias notes the tendency of decision makers to resend to various situations differently based on the context in which a choice is presented. Loss aversion: It can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround.
Escalation of commitment: Management scholars have documented a tendency of decision makers to escalate commitment to previously selected courses of action when objective evidence suggests that staying the course is unwise. Status quo bias: It is an emotional bias that predisposes people facing an array of choice options to elect whatever ratifies or extends the existing condition in lieu of alternative options that might bring about change. The gamblers fallacy: also known as the Monte Carlo fallacy and also referred to as the fallacy of the maturity of chances.
Self serving bias: It refers to the tendency of individuals to ascribe their successes to innate aspects. Money illusion: It refers to the tendency of people to think of currency in nominal, rather than real, terms.
Anomalies- Economic Behavior

An economic anomaly occurs when there is a difference between how standard economic theory predicts people should behave and how people actually behave.
Anomalies found in financial literature

Disposition Effect Endowment bias In equity reversion Reciprocity Inter Temporal Consumption Present- Biased Preferences Momentum Effect Greed and Fear Sunk cost fallacy
Disposition Effect
It refers to the pattern that people avoid realizing paper losses and seek to realize paper gains. People tend to have the disposition to sell the winner too early and to ride the losses too long. The disposition effect is consistent with the notion that realising profit allows one to maintain selfesteem but realising losses causes one to implicitly admit an erroneous investment decision and hence is avoided.
Endowment bias
Endowment bias is described as a mental process in which a differential weight is placed on the value of subject. It suggests that people place a higher value on something they already own than they would be prepared to pay to acquire it.
Inherited Securities
People are reluctant to sell securities bequeathed by previous generations.
Purchased Securities
Endowment bias often influences the value that an investor assigns to the recently purchased security. Rational economic theories predict that your willingness to pay (WTP) for the security would equal your willingness to accept (WTA) Once you are endowed to the purchased security you will probably demand a price which exceeds the purchase price.
Mitigation of Biases
Inherited Securities Purchased Securities Transaction Cost Aversion Desire for Familiarity
In equity reversion
It means that people resist inequitable outcomes. It is self centered if people do not care per se about inequity that exists among other people but are only interested in the fairness of their own material payoff relative to the payoff of others.
Reciprocity
It refers to responding to a positive action with another positive action rewarding kind actions. The focus of reciprocity is centered more on trading favours than making a negotiation. With reciprocity, a small favour can produce a sense of obligation to a larger return in favour.
Present-biased preferences
Research reveals that people often focus on short-term financial events to the detriment of their long term needs. Being biased towards the present at the expense of the future can prevent people from budgeting or committing themselves to a regular saving plan. Present-biased preference creates a time inconsitency problem.
Momentum effect
Momentum is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling.
Greed and fear

Greed and fear comes from certain neurological functions. House money effect, a tendency after an unexpected gain to feel like the gains are free money to play with.
Sunk cost fallacy

It makes us throw more good money after money already gone bad. People have strong misgiving about wasting resources ( Loss Aversion)
Anomalies- Market Prices and Returns Market anomalies or market inefficiency is a price and/or return distortion on a financial market that seems to contradict the efficient market hypothesis. There are anomalies in relation to the economic fundamentals of the equity, technical trading rules, and economic calendar events.
The Market Anomaly usually relates to

Structural factors, such as unfair competition, lack of market transparency, regulatory action, etc. Behavioral biases by economic agents
Types of market Anomalies:

Equity puzzle: It is based on the observation that in order to reconcile the much higher returns of stocks compared to government, individuals must have implausibly high risk aversion according to standard economics models. Limits to arbitrage: If irrational traders cause deviations from fundamental value, rational traders will often be powerless to do anything about it. Dividend puzzle: It deals with double-edged enigma of why individuals like dividends and why this method of income distribution persists in light of quite burdensome double taxation
Calendar anomaly: One calendar anomaly is known as The January Effect Fat tails: A financial fat tail describes a rare and extreme event. The term is derived from the inverted U-shaped bell curve that statisticians draw to describe the probability of events happening.
Group behavior
A tendency for individual to mimic the actions ( rational or irrational) of a larger group.
Types of Group behavior:
Confirmation bias Herd behavior
Confirmation bias
It refers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs. Impact on investors
People believe what they want to believe and ignore evidence to the contrary.
Herd behavior
People are influenced by their social environment and they often feel pressure to confirm. People buy the same stock which others are buying.
Cost of HERD Behavior

Frequent churning of portfolio which leads to substantial amount of transaction cost. It is extremely difficult to time trades correctly. Heard-Following investors mostly lose money as they enter too late in the game.
How to avoid the herd mentality

Just because everyone is jumping on a certain investment doesnt necessarily mean the strategy is correct. Always do your homework before following any trend. Particular investment favoured by the herd can easily become overvalued.
Investment Style and behavioral finance
Psychographic models are designed to classify individuals according to certain characteristics, tendencies, or behaviors.
Three models are used to understand investor psycograpics.

Barnewall Two-Way Model Bailard, Biehl and Kaiser Five-Way Model Pompain Behavioral Model
Barenwell Two-Way Model

Based on the work of Marilyn MacGruder Barnewal Distinguished between two relatively simple investor types: Passive investors and Active Investors
Passive Investors
Those investors who have become wealthy passively by inheritance or by risking the capital of others. Example: Professionals, Executives, Doctors. The smaller the economic resources an investor has, the more likely the person is to be a passive investor.
Active Invesors
Who have earned their own wealth in their lifetimes. They have been actively involved in the wealth creation and they have risked their own capital in achieving their wealth objective.
A simple non-invasive overview of an investors personal history and career could signal potential pitfall to guard against in an advisory relationship. A quick biographic glance at a client could provide an important context for portfolio design.
Bailard, Biehl and Kaiser Five-Way Model
Features some principles of the Barnewall Model but by classifying investor personalities along two axes- Lavel of confidence and method of action. Thomas Bailard, David Biehl and Ronal Kaiser provided a graphic representation of their model.
Bailard, Biehl and Kaiser 5 way model

CONFIDENT
individualistic
adventurer
CAREFUL
Straight arrow
IMPETUOUS
guardian
celebrity
ANXIOUS
Five investors personality types

The Adventurer The Celebrity The Individualist The Guardian The Straight Arrow
Pompian Behavioral Model

Developed in 2008 identifies four behavioral Investor types (BITs). 4 step process to determine the investor types
Steps:
Interview the client to determine if she is active or passive as an indication of her risk tolerance. Plot the investor on a risk tolerance scale Test for behavioral biases Classify the investor into one of the BITs
Pompian behavioral model: - Developed in 2008, identifies 4 behavioral investor type:

Investor type Passive preserver Friendly follower Independent individualistic Active accumulator High aggressive Risk tolerance low Investment style Conservative Decision making Emotional Cognitive Cognitive Emotional
The common emotional biases exhibited
Passive Preserver: Endowment, Loss aversion, Status Quo and Regret Aversion Friendly Follower: Regret Aversion Independent Individualist: Over confidence, self control Active Accumulator: Overconfidence, self control
The common cognitive biases exhibited
Passive Preserver: Mental accounting, Anchoring and Adjustment. Friendly Follower: Availability, Hindsight, Framing Independent Individualist: Conservatism, Availability, Confirmation, Representativeness, Active Accumulator: Illusion of control
Limitation of classifying investors into behavioral Types
Many times individuals act irrationally at unpredictable moments making it difficult to apply the different behavioral investor traits consistently for anyone investor over a period of time.
Individuals may simultaneously display both emotional biases and cognitive errors, all the while seeming to act rationally ,making it difficult to classified the individual according to behavioral biases. An individual might display traits of more than one behavioral investor types, making it difficult to place the individual into a single category. As investor age they will most likely to go through behavioral changes usually resulting in decreased risk tolerance along with becoming more emotional about their investing.
Even though two individuals may fall into the same behavioral investor type the individuals should not necessarily be treated the same due to their unique circumstances and psychological traits. Individual tend to act irrationally at unpredictable time because they are subject to their own specific psychological traits and persona circumstances in other words, people dont all act irrationally or rationally at the same time,
Behaviorally Modified Asset Allocation

Means constructing a portfolio according to the investors behavioral risk and return preferences. Probably not efficient from a modern portfolio theory perspective but investor is comfortable with it and likely to adhere to the strategy. Considers the investors emotional and cognitive behavioral biases and current wealth.
Suggested deviation from the rational
Cognitive Bias High Wealth/ Low SLR Modest Change +/- 5 to 10% maximum per asset class Almost no deviation +/- 0 to 3% maximum per asset class
Emotional Bias Large Change +/- 10 to 15% maximum per asset class Modest Change +/- 5 to 10% maximum per asset class
Low Wealth/ High SLR
The Nine Money Personalities

A classification produced by Kathleen Gurney of the Financial Psychology Corporation that stresses money style and how individuals react emotionally to financial decisions.
The nine personalities

Safety Players - those who take the path of least resistance, looking primarily for security and safety in their investments and doing what has worked previously. Entrepreneurs - a particularly male-dominated profile driven by a passion for excellence and commitment, and who are not motivated by money in itself. Financial success is a scorecard and stock investment is a method of implementing and demonstrating that success. Optimists- non-risk orientated, often near retirement, seeking peace of mind, these are investors who don't like to become too involved with their own financial management as it would cause them stress and reduce their enjoyment of life.
Hunters - often educated, high-earning women with an impulsive streak, a 'live now attitude'. They have a strong work ethic, much like entrepreneurs, but lack the same confidence in themselves. They may attribute their success to luck rather than ability. Achievers - conservative, risk-averse, these investors like to feel in control of their money, with security and protection of their assets a primary consideration. They are often, married, well educated, high-earners who feel that hard work and diligence is more likely to bring financial reward than investing.
Perfectionists - afraid of making financial mistakes, they tend to avoid investment decisions altogether. They lack confidence and self-esteem, and have low pride in handling financial matters, finding every conceivable excuse for not taking action. For them, no investment is without fault. Producers - highly committed to their work, they may earn less due to a lack of self-confidence in money management. And with a lack of basic financial knowledge they may have less available funds to invest. They do not appreciate how to evaluate risk appropriately.
High Rollers - thrill seekers, power seekers, creative and extroverted, they work hard and play hard. They have to be involved in high risk investing with a large amount of their assets. Financial security bores them - even though their actions may have financially dangerous consequences. Money Masters - tending to have a balanced financial outlook that gives contentment and security, these investors like to be involved with the management of their money and their choice of investments, although they will take onboard good, sound advice. They are determined individuals, not easily thrown of their chosen course, and who don't leave things to luck.
Psychonomic Investor Profiler

Investors are classified as either:
Cautious Emotional Technical Busy Casual or Informed
Cautious - very conservative, this investor has a need for financial security and will avoid high-risk ventures as well as listening to professional advice, preferring to conduct their own financial affairs. They don't like to lose even small amounts of money and never rush into investments, always giving financial opportunities a great deal of thought. Emotional - easily attracted to fashionable investments or 'hot' tips, these investors act with their heart and not their head. A whim or a gut feeling leads their decisions, and they have great difficulty disengaging from poor investments or cutting losses. They have an unreasonable belief that things will come right in the end and often put their trust in luck or 'providence' to safeguard their financial assets.
Technical - hard facts - numbers - lead this type of investor to active trading based on price movements. They are screenwatchers, sometimes obsessional, but their diligence can be rewarded if they spot trends. They may also have a tendency to 'need' and buy the latest technology as they are always looking for some edge.
Busy - these investors need to be involved with the markets, it gives them a buzz when they check the latest price movements, which may be several times a day. They have to keep buying and selling - on rumors, on overheard gossip, from the mass of newspapers and magazines they collect. Any tidbit of information they can glean is imbued with significance and a cause to take financial action.
Casual - a laid-back attitude to investment, these individuals are often hardworking and involved with work or family. They tend to believe that once an investment is made it will take care of itself, and that a good job or a profession is the way to make real money. They easily forget that they own investment assets and rarely check on their financial affairs. And, though they may leave the running of their investments to professional advisors, they haven't been in contact with them for years.
Informed - uses information from a variety of sources and keeps an ongoing watch on their investments, the markets and the economy. They listen carefully to financial opinions and expert assessments, and will only go against market fashion, as a contrarian, after weighing up all the pros and cons. They are financially confident and have faith in their decisions, knowing that knowledge and experience will always win out to give them long-term profits.
Pankaj Mathpal
CFPCM, CWM, CIWM, CPFA
www.optimamoney.com info@optimamoney.com facebook.com/optimamoney twitter.com/pankajmathpal linkedin.com/pankajmathpal

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LOGO LOGO

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

What is behavioral finance..?

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Efficient market hypothesis (EMH):

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

EMH frequently includes assumptions such as

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Limits of the efficient market hypothesis:

The limited arbitrage

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Utility preference theory

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Brief history of rational thought:

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Expected Utility Theory

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Then choose: Lottery C or Lottery D

Second choice: Portfolio C and D with following outcome

4 Rs. 900 Rs. 800

5 Rs. 1000 Rs. 900

6 Rs. 500 Rs. 1000

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Anchoring and adjustment:

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Two primary interpretation of representative bias apply to the individual investors

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Anomalies- Economic Behavior

Anomalies found in financial literature

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Greed and fear

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Sunk cost fallacy

The Market Anomaly usually relates to

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Types of market Anomalies:

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Cost of HERD Behavior

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

How to avoid the herd mentality

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Investment Style and behavioral finance

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Three models are used to understand investor psycograpics.

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Barenwell Two-Way Model

Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Pankaj Mathpal, CFP, CWM, CIWM, CPFA