Behavioural Finance

Dr.
Bushra
2 Syllabus
 Unit 1: Standard Finance and Utility Functions

Standard Finance, Market efficiency, Expected Utility Theory; Expected Utility

Theory and Rational Thought: Decision making under risk and uncertainty,
expected utility as a basis for decision-making, Theories based on Expected Utility
Concept, Investor rationality and market efficiency.

 Unit 2: Introduction to Behavioural Finance

Definition, behavioural finance micro and behavioural finance macro, important

contributors, components, difference with standard finance; Agency theory; Limits
to Arbitrage; Prospect theory, basic framework; Loss Aversion, model of loss
aversion; market anomalies.
3  Unit 3: Investor Behaviour

Types of investors, objectives of investment, factors influencing Investor decision

making, factors influencing investor personality, characteristics of successful
investors; behavioural finance viewpoint of risk, risk perception, factors affecting
risk attitude

 Unit 4: Behavioural Biases and Irrational Investing

Heuristics and Biases, representativeness heuristic, availability heuristic, affect

heuristic, similarity heuristic; Cognitive and Emotional Biases, Overconfidence
bias, cognitive dissonance bias, self-attribution bias, illusion of control bias,
conservatism bias, ambiguity aversion bias, endowment bias, self-control bias,
optimism bias, mental accounting bias, confirmation bias, hindsight bias, regret
aversion bias, status quo bias etc. Strategies to Overcome Biases.
4

 Unit 5: Recent Advances in Behavioural Finance

Neuro Finance, human brain, brain secretions, neuro technology; Noise Trading,

Behavioural Capital Asset Pricing Model, Behavioural Portfolio Theory, investor sentiments;

Conflict of Interest and Group Psychology on Board, contract theory.

Reference Books :-
1. Behavioral Finance - Psychology, Decision-Making, and Markets, Lucy F. Ackert and
Richard Deaves
2. Predictably Irrational, Dan Ariely
3. Behavioural Finance , Prasanna Chandra
 Course Outcomes:

 CO1: Understand the standard finance and utility functions as a tool to

make investment decisions.

 CO2: Evaluate behavioural aspects of financial markets and investment

decisions.

 CO3: Analyze the investment risk based on personality traits of investors.

 CO4: Assess how the investor behaviour and decision making is affected by
the respective heuristics and biases.

 CO5: Evaluate the impact of recent advances in individual and corporate

behavioural finance.
Behavioral Finance-An Overview

https://www.youtube.com/watch?
v=OG96I_Gc-gA
“The investor’s chief problem, and even his worst enemy, is
likely to be himself.”
— Benjamin Graham

“There are three factors that influence the market: Fear, Greed, and
Greed.”
— Market folklore
 Precursors to Behavioral
Finance
• Value investors proposed that markets over reacted to negative news.
• Benjamin Graham and David Dodd in their classic book, Security Analysis, asserted
that over reaction was the basis for a value investing style.

• David Dreman in 1978 argued that stocks with low P/E ratios were undervalued,
coining the phrase overreaction hypothesis to explain why investors tend to be
pessimistic about low P/E stocks.

• Tversky and Daniel Kahneman published two articles in 1974 in Science. They showed
heuristic driven errors, and in 1979 in Econometrica, they focused on representativeness
heuristic and frame dependence.
 Behavioral Finance Definitions

• Behavioral Finance, a study of investor market behavior that derives from psychological
principles of decision making, to explain why people buy or sell the stocks they do.
• The linkage of behavioral cognitive psychology, which studies human decision making, and
financial market economics.
• Behavioral Finance focuses upon how investors interpret and act on information to make
informed investment decisions.
• Investors do not always behave in a rational, predictable and an unbiased manner
indicated by the quantitative models.
• Behavioral finance places an emphasis upon investor behavior leading to various market
anomalies.
Use Psychology and Economics to Understand Finance

Asset Pricing: Personal Finance:

Corporate Finance:
• Price Anomalies
• IPO timing • Procrastination
• IPO underperformance
• Sentiment • Winner’s curse • Emotional choice
• Equity premium • Cash-flow sensitivity • Loss aversion
• PEA (Post Earning • Overconfidence • Narrow Framing
Announcement) drift • Superstar CEO’s • Return chasing
• Momentum : riding "hot" • Passivity
stocks and selling "cold" • Financial illiteracy
ones • Home bias
• Bubbles
• Overconfidence
• Wishful thinking
12 Introduction to Financial Markets
 Financial market is a market where people trade in financial
securities.
 Securities here includes:-
• Stocks and Bonds,
• Currencies and other financial instruments
• Derivatives

 Derivative market itself is a component of financial

market.

FD-BUSHRA October 17, 202

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13

Financia
l
Markets

Money Capital Forex

Market Market Market
FD-BUSHRA October 17, 202
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Capital
Market

Stock Debt
Market Market

Primary Secondar
Market y Market
FD-BUSHRA October 17, 202
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Stock Market

Primary Market Secondary Market

Spot Market (Cash

Derivative Market
Market)

Futures Options

Stock Index Currency Stock Index Currency

FD-BUSHRA October 17, 202

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 IPO
 An initial public offering (IPO) refers to the process of offering shares of
a private corporation to the public in a new stock issuance.
 Companies must meet requirements by exchanges and the Securities
and Exchange Commission (SEC) to hold an initial public offering (IPO).
 IPOs provide companies with an opportunity to obtain capital by
offering shares through the primary market.
 Companies hire investment banks to market, gauge demand, set the IPO
price and date, and more.
 An IPO can be seen as an exit strategy for the company’s
founders and early investors, realizing the full profit from their
private investment.
 CASE STUDY OF PAYTM IPO
 Post Earning Announcement Drift

 Post-earnings-announcement drift describes the tendency of stock

prices to continue to behave as if investors were still anticipating
corporate results, good or bad, despite the fact that the results have
been published and are widely known.
 Momentum : riding "hot" stocks and selling "cold" ones

 Momentum investing is an investment strategy that aims to capitalize on the

continuance of existing trends in the market. The momentum investor believes that large
increases in the price of a security will be followed by additional gains and vice versa for
declining values.

 This strategy looks to capture gains by riding "hot" stocks and selling "cold"
ones.

 To participate in momentum investing, a trader will take a long position in an asset,

which has shown an upward trending price, or short sell a security that has
been in a downtrend.

 The basic idea is that once a trend is established, it is more likely to continue in that
direction than to move against the trend.
 Procrastination

 Procrastination is the act of delaying or putting off tasks

until the last minute, or past their deadline.

 Some researchers define procrastination as a "form of self-

regulation failure characterized by the irrational delay of tasks
despite potentially negative consequences."
 An Introduction to
Behavioral Finance
• Efficient Markets Hypothesis
• Large number of market participants
• Incentives to gather and process information about securities and trade on
the basis of their analysis until individual participant’s valuation is similar to
the observed market price
• Prices in such markets reflect information available to the participants, which
means opportunities to earn above-normal rates of return on a consistent
basis are limited

• Prediction: Stock returns are (almost) impossible to predict except that riskier
securities on average, earning higher rates of returns compared to less risky
firms

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 Key Figures in the Field

In the past 10 years, some very thoughtful people have

contributed exceptionally brilliant work to the field of behavioral
finance.
 Professor Robert Shiller

 Robert James Shiller is an American economist, academic, and best-selling author. As of 2019,
he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale
School of Management's International Center for Finance.
 Nobel Memorial Prize in Economic Sciences,
 In Shiller’s Irrational Exuberance, which hit bookstores only days before the 1990s market
peaked, Professor Shiller warned investors that stock prices, by various historical measures, had
climbed too high. He cautioned that the “public may be very disappointed with the performance
of the stock market in coming years.”
 It was reported that Shiller’s editor at Princeton University Press rushed the book to print,
perhaps fearing a market crash and wanting to warn investors. Sadly, however, few heeded the
alarm.
 Professor Richard Thaler

 Richard H. Thaler is an American economist and the Charles R. Walgreen Distinguished Service
Professor of Behavioral Science and Economics at the University of Chicago Booth School of
Business. In 2015, Thaler was president of the American Economic Association.
 Nobel Memorial Prize in Economic Sciences (2017)
 Ph.D., of the University of Chicago Graduate School of Business, penned a classic commentary
with Owen Lamont entitled “Can the Market Add and Subtract? Mispricing in Tech Stock
Carve-Outs,” also on the general topic of irrational investor behavior set amid the tech bubble.
 The work related to 3Com Corporation’s 1999 spin-off of Palm, Inc. It argued that if investor
behavior was indeed rational, then 3Com would have sustained a positive market value for a
few months after the Palm spin-off. In actuality, after 3Com distributed shares of Palm to
shareholders in March 2000, Palm traded at levels exceeding the inherent value of the shares of
the original company. “This would not happen in a rational world,” Thaler noted. (Professor
Thaler is the editor of Advances in Behavioral Finance, which was published in 1993.)
 Professor Kahneman
 Kahneman found that under conditions of uncertainty, human decisions systematically
depart from those predicted by standard economic theory. Kahneman, together with Amos
Tversky (deceased in 1996), formulated prospect theory. An alternative to standard
models, prospect theory provides a better account for observed behavior and is discussed

 Smith also performed “wind-tunnel tests” to estimate the implications of alternative

market configurations before such conditions are implemented in practice. The
deregulation of electricity markets, for example, was one scenario that Smith was able to
model in advance. Smith’s work has been instrumental in establishing experiments as an
essential tool in empirical economic analysis at length in later chapters. Kahneman also
discovered that human judgment may take heuristic shortcuts that systematically diverge
from basic principles of probability.
 Behavioral Finance Micro versus Behavioral
Finance Macro
 As we have observed, behavioral finance models and interprets phenomena ranging from
individual investor conduct to market-level outcomes. Therefore, it is a difficult subject to
define.
 we break our topic down into two subtopics: Behavioral Finance Micro and Behavioral
Finance Macro.
1. Behavioral Finance Micro (BFMI) examines behaviors or biases of individual investors
that distinguish them from the rational actors envisioned in classical economic theory.
2. Behavioral Finance Macro (BFMA) detects and describe anomalies in the efficient market
hypothesis
For wealth management practitioners and investors, our primary focus should be BFMI, the
study of individual investor behavior. Specifically, to identify relevant psychological biases and
investigate their influence on asset allocation decisions.
 The Two Great Debates Of Standard Finance
Versus Behavioral Finance
This section reviews the two basic concepts in standard finance that behavioral finance
disputes: rational markets and rational economic man.

 Standard finance theory is designed to provide mathematically elegant

explanations for financial questions that, when posed in real life, are often
complicated by imprecise, inelegant conditions. The standard finance approach relies on
a set of assumptions that oversimplify reality.

 For example, embedded within standard finance is the notion of “Homo Economicus,”
or rational economic man. It prescribes that humans make perfectly rational economic
decisions at all times. Standard finance, basically, is built on rules about how investors
“should” behave, rather than on principles describing how they actually behave.
Behavioral finance attempts to identify and learn from the human psychological
phenomena at work in financial markets and within individual investors.
 Efficient Markets versus Irrational
Markets

 During the 1970s, the standard finance theory of market efficiency became the model
of market behavior accepted by the majority of academics and a good number of
professionals. The Efficient Market Hypothesis had matured in the previous decade,
stemming from the doctoral dissertation of Eugene Fama.

 Fama persuasively demonstrated that in a securities market populated by many well-

informed investors, investments will be appropriately priced and will reflect all

available information.
 Efficient Markets versus Irrational Markets

 There are three forms of the efficient market hypothesis

1. The “Weak” form contends that all past market prices and data are fully
reflected in securities prices; that is, technical analysis is of little or no value.

2. The “Semi strong” form contends that all publicly available information is
fully reflected in securities prices; that is, fundamental analysis is of no value.

3. The “Strong” form contends that all information is fully reflected in securities
prices; that is, insider information is of no value.
 Historical Roots – Case of Irrationality

Investor irrationality has existed as long as the markets themselves have. Perhaps the best-
known historical example of irrational investor behavior dates back to the early modern or
mercantilist period during the sixteenth century.

 A man named Conrad Guestner transported tulip bulbs from Constantinople,

introducing them to Holland. Beautiful and difficult to obtain, tulips were a consumer
sensation and an instant status symbol for the Dutch elite. Although most early buyers
sought the flowers simply because they adored them, speculators soon joined the fray to
make a profit. Trading activity escalated, and eventually, tulip bulbs were placed onto the
local market exchanges.
 Historical Roots –Irrationality

 It wasn’t until the mid-eighteenth-century onset of the classical period in economics,

however, that people began to study the human side of economic decision making, which
subsequently laid the groundwork for behavioral finance micro.

 At this time, the concept of utility was introduced to measure the satisfaction associated with
consuming a good or a service. Scholars linked economic utility with human psychology and
even morality, giving it a much broader meaning than it would take on later, during
neoclassicism, when it survived chiefly as a principle underlying laws of supply and demand.
 Many people think that the legendary Wealth of Nations (1776) was what made Adam Smith

famous; in fact, Smith’s crowning composition focused far more on individual psychology
than on production of wealth in markets. Published in 1759, The Theory of Moral
Sentiments described the mental and emotional underpinnings of human interaction,
including economic interaction.

 In Smith’s time, some believed that people’s behavior could be modeled in completely

rational, almost mathematical terms. Others, like Smith, felt that each human was born
possessing an intrinsic moral compass, a source of influence superseding externalities like
logic or law. Smith argued that this “invisible hand” guided both social and economic
aspects.
 Rational Economic Man
 Rational economic man (REM) describes a simple model of human behavior. REM strives to maximize
his economic well-being, selecting strategies that are contingent on predetermined, utility-optimizing
goals, on the information that REM possesses, and on any other postulated constraints.

 The amount of utility that REM associates with any given outcome is represented by the output of his
algebraic utility function.

 Basically, REM is an individual who tries to achieve discretely specified goals to the most
comprehensive, consistent extent possible while minimizing economic costs.

 REM’s choices are dictated by his utility function. Often, predicting how REM will negotiate complex
trade-offs, such as the pursuit of wages versus leisure, simply entails computing a derivative.

 REM ignores social values, unless adhering to them gives him pleasure
 Cognitive Psychology
 Many scholars of contemporary behavioral finance feel that the field’s most direct roots are in
cognitive psychology.

 Cognitive psychology is the scientific study of cognition, or the mental processes that are believed to
drive human behavior. Research in cognitive psychology investigates a variety of topics, including
memory, attention, perception, knowledge representation, reasoning, creativity, and problem solving.

 Decision Making under Uncertainty

Each day, people have little difficulty making hundreds of decisions. This is because the best course of
action is often obvious and because many decisions do not determine outcomes significant enough to
merit a great deal of attention. On occasion, however, many potential decision paths emanate, and the
correct course is unclear. Sometimes, our decisions have significant consequences.
These situations demand substantial time and effort to try to devise
a systematic approach to analyzing various courses of action :-

1. Take an inventory of all viable options available for obtaining information,

for experimentation, and for action.

2. List the events that may occur.

3. Arrange pertinent information and choices/assumptions.

4. Rank the consequences resulting from the various courses of action.

5. Determine the probability of an uncertain event occurring.

 An Introduction to
Behavioral Finance
• Behavioral finance
• Widespread evidence of anomalies is inconsistent with the efficient markets
theory
• Bad models, data mining, and results by chance
• Alternatively, invalid theory
• Anomalies as a pre-cursor to behavioral finance
• Challenge in developing a behavioral finance theory of markets
• Evidence of both over- and under-reaction to events
• Event-dependent over- and under-reaction, e.g., IPOs, dividend initiations, seasoned equity
issues, earnings announcements, accounting accruals

• Horizon dependent phenomenon: short-term overreaction, medium-term momentum,

and long-run overreaction
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 An Introduction to
Behavioral Finance
Behavioral finance theory rests on the following three
assumptions/characteristics:-

I. Investors exhibit information processing biases that cause them to

over- and under-react

II. Individual investors’ errors/biases in processing information must be

correlated across investors so that they are not averaged out

III. Limited arbitrage: Existence of rational investors should not be

sufficient to make markets efficient

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 Behavioral Finance Theories -
Assumptions
I. HUMAN INFORMATION PROCESSING BIASES
• Information processing biases are generally relative to the Bayes rule
for updating our priors on the basis of new information
• Two biases are central to behavioral finance theories
• Representativeness bias (Kahneman and Tversky, 1982)
• Conservatism bias (Edwards, 1968).
• Other biases: Over confidence and biased self-attribution

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 I. Human information processing biases
• Representativeness bias causes people to over-weight recent information
and deemphasize base rates or priors
• E.g., conclude too quickly that a yellow object found on the street is gold (i.e., ignore the
low base rate of finding gold)

• People over-infer the properties of the underlying distribution on the

basis of sample information
• For example, investors might extrapolate a firm’s recent high sales growth and thus
overreact to news in sales growth

• Representativeness bias underlies many recent behavioral finance models of market

inefficiency

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 I. Human information processing biases
• Conservatism bias: Investors are slow to update their beliefs, i.e., they
underweight sample information which contributes to investor under-reaction to
news
• Conservatism bias implies investor under reaction to new information
• Conservatism bias can generate
• short-term momentum in stock returns

• The post-earnings announcement drift, i.e., the tendency of stock prices to drift in the
direction of earnings news for three-to-twelve months following an earnings announcement
also entails investor under-reaction

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 I. Human information processing biases
• Investor‘s overconfidence
• Overconfident investors place too much faith in their ability to process information
• Investors overreact to their private information about the company’s prospects

• Biased self-attribution
• Overreact to public information that confirms an investor’s private information
• Underreact to public signals that disconfirm an investor’s private information
• Contradictory evidence is viewed as due to chance
• Genrate underreaction to public signals

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 I. Human information processing biases

• Investor overconfidence and biased self-attribution

• In the short run, overconfidence and biased self-attribution together result in a continuing
overreaction that induces momentum.
• Subsequent earnings outcomes eventually reveal the investor overconfidence, however, resulting
in predictable price reversals over long horizons.
• Since biased self-attribution causes investors to down play the importance of some publicly
disseminated information, information releases like earnings announcements generate
incomplete price adjustments.

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 Behavioral finance theories -
Assumptions
II. In addition to exhibiting information-processing biases, the biases must be
correlated across investors so that they are not averaged out
• People share similar heuristics,
• Focus on those that worked well in our evolutionary past
Therefore, people are subjected to similar biases.
Experimental psychology literature confirms systematic biases among
people

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 Behavioral Finance Theories -
Assumptions
III. Limited arbitrage
• Efficient markets theory is predicted on the assumption that market
participants with incentives to gather, process, and trade on information will
arbitrage away systematic mispricing of securities caused by investors’
information processing biases.

• Arbitrageurs will earn only a normal rate of return on their information-

gathering activities :-
• Market efficiency and arbitrage: EMH assumes arbitrage forces are
constantly at work
• Economic incentive to arbitrageurs exists only if there is mispricing, i.e.,
mispricing exists in equilibrium
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 III. Limited arbitrage
• Behavioral finance assumes arbitrage is limited.
• What would cause limited arbitrage?
• Economic incentive to arbitrageurs exists only if there is mispricing.
Therefore, mispricing must exist in equilibrium
• Existence of rational investors must not be sufficient
• Notwithstanding arbitrageurs, inefficiency can persist for long periods because
arbitrage is costly :-
• Trading costs: Brokerage, B-A spreads, price impact/slippage (the
discrepancy between the expected price of a trade and the price at
which the trade is executed)

• Holding costs: Duration of the arbitrage and cost of short selling

• Information costs: Information acquisition, analysis and monitoring 18
 III. Limited arbitrage
• Why can’t large firms end limited arbitrage?
• Arbitrage requires gathering of information about a firm’s prospects, spotting of mispriced
securities, and trading in the securities until the mispricing is eliminated
• Analysts with the information typically do not have the capital needed for trading

• Firms (principals) supply the capital, but they must also delegate decision making (i.e.,
trading) authority to those who possess the information (agents)
• Agents cannot transfer their information to the principal, so decisions must be made by those who
possess information

• Agents are compensated on the basis of outcomes, but the principal sets limits on the amount of
capital at the agent’s disposal
• Limited capital means arbitrage can be limited
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 Behavioral finance
theories
• Like the efficient markets theory, behavioral finance makes
predictions about pricing behavior that must be tested
• Need for additional careful work in this respect
• Only then, we can embrace behavioral finance as an adequate
descriptor of the stock market behavior
• Recent research in finance is in this spirit just as the anomalies
literature documents inconsistencies with the efficient markets
hypothesis

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 Introduction

 Economic theorists believe that investors think and behave “rationally’

when buying and selling of stocks.

 Specifically, they are presumed to use all available information to form

“rational expectations” about the future in determining the value of
companies and the general health of the economy.

 Consequently, stock prices should accurately reflect fundamental mental

values and will only move up and down when there is unexpected positive
or negative news, respectively.
 Introduction Con…

 Thus, economists have concluded that financial markets are stable and
efficient, stock prices follow a “random walk” and the overall economy
tends toward “general equilibrium”.
 In reality however, according to Shiller (1999) investors do not think and
behave rationally. In the contrary, investors are driven by greed and fear
under uncertainty.
 In other words, investors are misinformed by extremes of emotion,
subjective thinking, and the whims of the crowd, consistently from
irrational expectation for the future performance of companies and the
overall economy.
 Introduction Cont.…
 Since 1950s, the field of finance has been dominated by traditional finance
model (Standard finance model).
 Key assumption-people are rational.
 However, Behaviorists/Psychologists challenged this assumption.
 People often suffer from cognitive and emotional biases and act in a
seemingly irrational manner.
 The finance field was reluctant to accept this view of psychologist
who proposed behavioral finance model.
 As the evidence of the influence of psychology and emotions on decisions
became more convincing, behavioral finance has received greater acceptance.
2002 Nobel Prize in Economics to psychologists Daniel Kahneman and
experimental economist Vernon Smith substantiated the field of Behavioral
Finance.
 Behavioral Finance-Definition

 Behavioral Finance (BF) is a field of finance that proposes psychology based

theories to explain stock market anomalies.
 Investors behavior is part of academic discipline known as “behavior finance”
which explains how emotions and cognitive errors influence investors and
decision making process.
 BF involves research that drops the traditional assumptions of expected
utility maximization with rational investors in efficient markets.
 BF is of interest because it helps to explain why and how markets might be
inefficient.
 Two Building blocks of Behavioral
Finance
Behavioral Finance

Limits to arbitrage (When

Cognitive psychology
markets will be inefficient?)
(How people think?)
 Behavioral Finance has two building blocks: cognitive psychology and the
limits to arbitrage.
 Cognitive refers to how people think. There is a huge psychology literature
that people make systematic errors in the way that they think.
 They seem to be overconfident and basically put too much weight on
recent experience. Their preferences may also create
distortions/misrepresentations.
 Limits to arbitrage refers to predicting in what circumstances arbitrage
forces will be effective, and when they won’t be.
 Traditional Finance vs. Behavioral
Finance
 Traditional finance falls into the following basic paradigms:
a) portfolio is based on the expected return and risk,
b) is subject to risk based on CAPM,
c) the pricing of contingent claims,
d) Modigliani-Miller theorem.

 All of these ideas came from investors’ rationality. However, the traditional
finance does not respond to the following questions:
a) why does an investor trade?
b) how does an investor trade?
c) how does an investor compose portfolios?
d) and finally, why do stock returns vary not due to the risk?
 Traditional Finance Behavioral Finance
1. People process data appropriately and 1. People employ imperfect rules of thumb (heuristics)
correctly. to process data which includes biases in their beliefs and
predisposes them to commit errors.

2. People view all decisions through the 2.Perceptions of risk and return are significantly
transparent and objective lens of risk and influenced by how decisions problems are framed
return (inconsequential frame definition). (frame dependence).

3.People are guided by reason and logic and 3. Emotions and herd instincts play an important
independent judgement. role in influencing decisions.

4. Markets are efficient. Market price of each 4. Heuristic-driven biases and errors, frame dependence,
security is an unbiased estimate of its and effects of emotions and social influence often lead
intrinsic value. to discrepancy between market price and fundamental
value.
 Investors’
Psychology
 BF is an important subfield of finance which combines psychology and
economics to explain why and how investors act and to analyze how that
behavior affects the market.

 Indeed, it attempts to explain the decisions of investors by viewing them as

rational actors looking out of their self-interest, given the sometimes
inefficient nature of the market.

 Tracing its origins to Adam Smith’s “The Theory of Moral Sentiments”, one of
its primary observations holds that investors (and people in general) make
decisions on imprecise impressions and beliefs rather than rational analysis.
 Investors’ Psychology Cont…
 A second observation states that the way a question or problem is framed
to an investor will influence the decision he/she ultimately makes.

 These two observations largely explain market inefficiencies, that is BF

holds that markets are sometimes inefficient because people are not
mathematical equations. BF stands in contrast to the efficient market
theory.

 Within behavioral finance, it is assumed that the information structure and

the characteristics of market participants systematically influence
individuals’ investment decisions as well as outcomes.
 Investors’ psychology
Cont…
According to Kent, et.al. (2001), the most common behavior that most
investors do when making investment decision are:
Investors often do not participate in all asset and security categories,
Individual investors exhibit loss-averse behavior,
Investors use past performance as an indicator of future
performance in stock purchase decisions,
Investors trade too aggressively,
Investors behave in status quo,
Investors do not always form efficient portfolios,
Investors behave parallel to each other, and
Investors are influenced by historical high or low trading stocks.
 Market Psychology-Definition

 Market psychology refers to the overall sentiment or feeling that the market is
experiencing at any particular time.
 The factors driving the group's overall investing mentality or sentiment are:
 Greed
 Fear
 Expectations, and
 Circumstances
 Whereas conventional financial theory describes situations in which all the
players in the market behave rationally.
 Technical analysts use trends, patterns, and other indicators to anticipate whether
the market is heading in an upward or downward direction.
 How Market Psychology Works?

 Peoples’ perceptions of the market directly impact price movements and

trends.
 Market psychology is the overall feeling among market participants that
impels them to buy or sell.
 For this reason, an upward or bullish trend is associated with feelings of
positive expectations expressed by optimism and hopefulness.
 By contrast, a downward or bearish trend correlates with feelings of
pessimistic expectations expressed by anxiety and fear.
 Why it matters?

 The nature of market psychology suggests that any given trend may be
more indicative of market sentiment than of fundamental gains or losses in
the value of the stocks.
 The Five-Factor Model Of Personality

“The Big Five” or “Five-Factor Model” (Goldberg,

1990; McCrae & Costa, 1987; McCrae & John, 1992)
 The Big Five comprises five major
traits shown

 A way to remember these five is with the acronym OCEAN

 O is for Openness;

 C is for Conscientiousness;

 E is for Extraversion;

 A is for Agreeableness;

 N is for Neuroticism).
 Descriptions of the Big Five Personality Traits

Big Five Trait Definition

Openness The tendency to appreciate new art, ideas, values, feelings, and behaviors

The tendency to be careful, to be on-time for appointments, to follow rules, and to be

Conscientiousness
hardworking

The tendency to be talkative, to be sociable, and to enjoy others; the tendency to have
Extraversion
a dominant style

The tendency to agree and go along with others rather than to assert one’s own
Agreeableness
opinions and choices

The tendency to frequently experience negative emotions such as anger, worry, and
Neuroticism
sadness; the tendency to be interpersonally sensitive
 Example Behaviors for Those Scoring low and
High for the Big Five Traits
Big Five Trait Example Behavior for LOW Scorers Example Behavior for HIGH Scorers

Prefers not to be exposed to alternative moral Enjoys seeing people with new types of
Openness systems; narrow interests; inartistic; not haircuts and body piercing; curious;
analytical; down-to-earth imaginative; untraditional

Never late for a date; organized;

Prefers spur-of-the-moment action to
Conscientiousness hardworking; neat; persevering; punctual;
planning; unreliable; hedonistic; careless; lax
self-disciplined

Prefers a quiet evening reading to a loud Is the life of the party; active; optimistic;
Extraversion
party; sober; aloof; unenthusiastic fun-loving; affectionate

Quickly and confidently asserts own rights; Agrees with others about political opinions;
Agreeableness
irritable; manipulative; uncooperative; rude good- natured; forgiving; gullible; helpful

Not irritated by small annoyances; calm; Constantly worries about little things;
Neuroticism
unemotional; hardy; secure; self-satisfied insecure; hypochondriacal; feels inadequate
 Personality Traits and Risk Profile
Influencing Attitude of Investor
 The five factor model delineates five broad traits:

Personality Traits and Risk

Profile of Investors

Extraversi Agreeablene Conscientiousne Openness

on Neuroticism
ss ss to
Experienc
e

 These traits, sometimes designated as domains, were originally derived from a

categorization of the adjectives that are commonly used to describe individuals.
 Personality Traits And Risk Profile Influencing
Attitude Of Investor Cont.…

1. Extraversion: A person high in extraversion tends to be more sociable, active,

optimistic, fun loving and talkative while someone low in extraversion tends to
be reserved, aloof and quiet.

2. Agreeableness: An individual high in agreeableness tends to be trusting

altruistic, good natured, empathic and helpful. Yet someone low in
agreeableness tends to be clinical rude, suspicious, non-cooperative, irritable
and even manipulative , vengeful and ruthless.

3. Conscientiousness: It refers to the degree of organization control, persistence

and motivation to goal directed behavior. A person high in conscientiousness
tends to be lazy, aimless, hedonistic careless
4.Neuroticism: It refers to a person’s level of emotional stability.
Individuals high in neuroticism are more prone to psychological distress
including negative affectivity such as anger, hostility, depression and
anxiety.

5.Openness to experience: It refers to the active seeking and appreciation

for their own sake. People high in openness are imaginative, curious and
openness to unconventional ideas and values. On the other hand, those
low in openness tend to be conventional and dogmatic in beliefs and
attitudes, set in their ways and emotionally unresponsive.
 The five-factor model of personality is the dominant paradigm in personality
research (Mc crae 2009).

 It encapsulates individual’s personalities using five traits, the ‘Big Five’

model. These personality traits are strongly rooted in biology and are
genetically based. Neuroscience uses traits to provide a common structure to
map the structure of the brain on to certain behaviors.