INTRODUCTION TO BUSINESS INVESTMENTS

Understanding Behavioral Finance

Behavioral finance attempts to explain how decision makers take financial decisions in real life, and why their
decisions might not appear to be rational every time and, therefore, have unpredictable consequences. This is in
contrast to many traditional theories which assume investors make rational decisions.

Terms in Behavioral Finance

Market Paradox.
This occurs because in order for markets to be efficient, investors have to believe that they are inefficient. This is
because if investors believe markets are efficient, there would be no point in actively trading shares –which would
mean that markets would not react efficiently to new information.

Herding
This refers to when investors buy or sell shares in a company or sector because many other investors have already
done so. Explanations for investors following a herd instinct include social conformity, the desire not to act differently
from others. Following a herd instinct may also be due to individual investors lacking the confidence to make their
own judgements, believing that a large group of other investors cannot be wrong.
If many investors follow a herd instinct to buy shares in a certain sector. This can result in significant price rises for
shares in that sector and lead to a stock market bubble (a bubble is an economic cycle characterized by the rapid
escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the
fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the
elevated price, a massive sell-off occurs, causing the bubble to deflate).

There is also evidence to suggest that stock market ‘professionals’ often do not base their decisions on rational
analysis. Studies have shown that there are traders in stock markets who do not base their decisions on fundamental
analysis of company performance and prospects. They are known as noise traders. Characteristics associated with
noise traders include making poorly timed decisions and following trends.

Loss Aversion
Some investors may have loss aversion, avoiding investments that have the risk of making losses, even though
expected value analysis suggests that, in the long-term, they will make significant capital gains. Investors with loss
aversion may also prefer to invest in companies that look likely to make stable, but low profits, rather than companies
that may make higher profits in some years but possibly losses in others.

Momentum Effect
There may be a momentum effect in stock markets. A period of rising share prices may result in a general feeling of
optimism that prices will continue to rise and an increased willingness to invest in companies that show prospects for
growth. If a momentum effect exists, then it is likely to lengthen periods of stock market boom or bust.

Behavioral finance can be analyzed from a variety of perspectives. Stock market returns are one area of finance where
psychological behaviors are often assumed to influence market outcomes and returns but there are also many different
angles for observation. The purpose of classification of behavioral finance is to help understand why people make
certain financial choices and how those choices can affect markets. Within behavioral finance, it is assumed that
financial participants are not perfectly rational and self-controlled but rather psychologically influential with
somewhat normal and self-controlling tendencies.

One of the key aspects of behavioral finance studies is the influence of biases. Biases can occur for a variety of reasons.
Biases can usually be classified into one of five key concepts. Understanding and classifying different types of
behavioral finance biases can be very important when narrowing in on the study or analysis of industry or sector
outcomes and results.
• Behavioral finance is an area of study focused on how psychological influences can affect market outcomes.
• Behavioral finance can be analyzed to understand different outcomes across a variety of sectors and
industries.

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 • One of the key aspects of behavioral finance studies is the influence of psychological biases.

Behavioral Finance Concepts

Behavioral finance typically encompasses five main concepts:

(a) Mental accounting

Mental accounting refers to the propensity for people to allocate money for specific purposes. It refers to the different
values people place on money, based on subjective criteria, that often has detrimental results. Mental accounting is a
concept in the field of behavioral economics. Developed by economist Richard H. Thaler, it contends that individuals
classify funds differently and therefore are prone to irrational decision-making in their spending and investment
behavior.
Mental accounting often leads people to make irrational investment decisions and behave in financially
counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card
balances.

(b) Herd behavior

Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious
in the stock market as the cause behind dramatic rallies and sell-offs.

(c) Emotional gap

The emotional gap refers to decision making based on extreme emotions or emotional strains such as anxiety, anger,
fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices.

(d) Anchoring
Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently
based on a budget level or rationalizing spending based on different satisfaction utilities.
Anchoring is the use of irrelevant information, such as the purchase price of a security, as a reference for evaluating
or estimating an unknown value of a financial instrument.

An anchoring bias can cause a financial market participant, such as a financial analyst or investor, to make an incorrect
financial decision, such as buying an undervalued investment or selling an overvalued investment. Anchoring bias can
be present anywhere in the financial decision-making process, from key forecast inputs, such as sales volumes and
commodity prices, to final output like cash flow and security prices.

Customers for a product or service are typically anchored to a sales price based on the price marked by a shop or
suggested by a salesperson. Any further negotiation for the product is in relation to that figure, regardless of its actual
cost.
Within the investing world, anchoring bias can take on several forms. In one instance, traders are typically anchored
to the price at which they bought a security. For example, if a trader bought stock ABC for Kshs.1,000, then she will
be psychologically fixated on that price for a sale or further purchases of the same stock, regardless of ABC's actual
value based on an assessment of relevant factors affecting it.

(e) Self-attribution
Self-attribution refers to a tendency to make choices based on a confidence in self-based knowledge. Self-attribution
usually stems from intrinsic confidence of a particular area. Within this category, individuals tend to rank their
knowledge higher than others.

Biases in Behavioral Finance

Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance
analysis, including:

Disposition Bias
Disposition bias refers to when investors sell their winners and hang onto their losers. Investors' thinking is that they
want to realize gains quickly. However, when an investment is losing money, they'll hold onto it because they want

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to get back to even or their initial price. Investors tend to admit they are correct about an investment quickly (when
there's a gain). However, investors are reluctant to admit when they make an investment mistake (when there's a loss).
The flaw in disposition bias is that the performance of the investment is often tied to the entry price for the investor.
In other words, investors gauge the performance of their investment based on their individual entry price disregarding
fundamentals or attributes of the investment that may have changed.

Confirmation Bias
Confirmation bias is when investors have a bias toward accepting information that confirms their already-held belief
in an investment. If information surfaces, investors accept it readily to confirm that they're correct about their
investment decision—even if the information is flawed.

Experiential Bias
An experiential bias occurs when investors' memory of recent events makes them biased or leads them to believe that
the event is far more likely to occur again. For example, the financial crisis in 2008 and 2009 led many investors to
exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the
coming years. The experience of having gone through such a negative event increased their bias or likelihood that the
event could reoccur. In reality, the economy recovered, and the market bounced back in the years to follow.

Loss Aversion
Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market
gains. In other words, they're far more likely to try to assign a higher priority on avoiding losses than making
investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout
isn't likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational
standpoint.

Familiarity Bias
The familiarity bias is when investors tend to invest in what they know, such as domestic companies or locally owned
investments. As a result, investors are not diversified across multiple sectors and types of investments, which can
reduce risk. Investors tend to go with investments that they have a history with or have familiarity.

Representativeness Bias
Two primary interpretations of representativeness bias apply to individual investors. One is base‐rate neglect and the
other is sample‐size neglect. Some investors tend to rely on stereotypes when making investment decisions. In sample‐
size neglect, investors, when judging the likelihood of a particular investment outcome, often fail to accurately
consider the sample size of the data on which they base their judgments. Both types of representativeness bias, base‐
rate neglect and sample‐size neglect, can lead to substantial investment mistakes. Investors can make significant
financial errors when they examine a money manager's track record. Investors also make similar mistakes when they
investigate track records of stock analysts.

Status Quo Bias

Status quo bias refers to the phenomenon of preferring that one's environment and situation remain as they already
are. The phenomenon is most impactful in the realm of decision-making: when we make decisions, we tend to prefer
the more familiar choice over the less familiar, but potentially more beneficial, options.

Investor Sentiment
The general mood among investors regarding a particular market or asset. You can gauge investor sentiment by
reviewing the trading activity and direction of prices within a particular market. For example, rising prices would
point to positive investor sentiment.
Investor sentiment isn't an exact science. That's because along with things like economic reports and global events,
it's driven by emotion.
It's important to remember that investor sentiment doesn't always provide a true indicator of future price movements.

Over and Underreaction in Behavioral Finance

Overreaction is an emotional response to new information. In finance and investing, it is an emotional response to a
security like a stock or other investment, which is led either by greed or fear. Investors, overreacting to news, cause
the security to become either overbought or oversold, until it returns to its intrinsic value.

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An overreaction in financial markets is when prices become excessively overbought or oversold due to psychological
reasons rather than fundamentals.
Some of the most influential work in behavioral finance concerns the initial under-reaction and subsequent
overreaction of prices to new information.
In contrast to overreaction, under-reaction to new information is more likely to be permanent and is caused by
anchoring, a term that describes people's attachment to old information, which is especially strong when that
information is critical to a coherent way of explaining the world (also known as a hermeneutic) held by the investor.
Anchoring ideas like "brick and mortar retail stores are dead" can cause investors to miss undervalued stocks and
opportunities for profit.

Behavioral Portfolio Theory (BPT)

Behavioral portfolio theory (BPT), provides an alternative to the assumption that the ultimate motivation for investors
is the maximization of the value of their portfolios. It suggests that investors have varied aims and create an investment
portfolio that meets a broad range of goals. It does not follow the same principles as the capital asset pricing model,
modern portfolio theory and the arbitrage pricing theory. A behavioral portfolio bears a strong resemblance to a
pyramid with distinct layers. Each layer has well defined goals. The base layer is devised in a way that it is meant to
prevent financial disaster, whereas, the upper layer is devised to attempt to maximize returns, an attempt to provide a
shot at becoming rich.

Figure: Behavioral Portfolio Theory

Fundamental Investing Principles

1. Embrace an Investing Strategy

It’s important to know what kind of investor you are and adhere to the principles of your investing strategies. What
kind of investor are you; value, contrarian, growth at a reasonable price, growth, or momentum?

If you choose to be a value investor you are at the right place to learn more. Investment decisions should be valuation-
based. Whichever investing strategies you choose, maintain a consistent approach. In other words, a value investor
should not be participating in momentum investing.

2. Invest With a Margin of Safety

If you buy an asset for less than its real value, you have a margin of safety. The best plan to lower risk is to buy
investments at a price that is lower than the real or intrinsic value.

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A low price means greater upside appreciation if conditions are favorable. At the same time, a low price provides a
margin of safety if circumstances are not ideal. Always plan on less than ideal conditions, something usually goes
wrong.

3. Asset Allocation

Decision on the division of portfolio among different asset categories, will be the biggest determinant of investment
returns. Many investors fail because they put little thought or effort into their asset allocation strategy.

If one places money into overvalued asset categories, he/she will experience poor long term returns. It’s important to
overweight asset categories that are bargain priced and underweight or avoid asset categories that are expensive.

4. Diversification is Vital

Investment diversification in small numbers provides enormous benefits. In other words, five investments is much
better than two, ten investments is better than five. However, the marginal benefits of adding additional investments
decreases as the numbers get larger until the costs become greater than the benefits.

Both under diversification and over diversification are common mistakes made in portfolio management. Most studies
show optimization occurs somewhere between 15 and 30 individual investments.

5. Employ Risk Control Strategies

Because it is so important to not lose your principal you must employ risk control strategies. Portfolio volatility is an
investment return killer. If you don’t control risk you will suffer greatly in bear markets. Avoiding large portfolio
drawdowns should be one of your preeminent investing principles.

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