Behavioral Finance

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Behavioral Finance

Pankaj Mathpal CFPCM, CWM, CIWM, CPFA

Contents

Introduction to Behavioral Finance

Efficient Market Hypothesis

Paradoxes

Utility Preference Theory

Pascal-Fermat to Friedman-Savage

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 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. 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 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,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 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, past price and volume data as well as firms,

market and investment specific information.


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

Brief history of rational thought:

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 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 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 decisionbetween 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 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

0.50.5

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 1 2 3 4 5 6


Dice

outcome

1 2 3 4 5 6

Scheme A Rs.600 Rs.700 Rs.800 Rs. 900 Rs. 1000 Rs. 500

Scheme B Rs.500 Rs.600 Rs.700 Rs. 800 Rs. 900 Rs. 1000

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 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 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 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 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 Categorization

Narrow range of experience

Resonance


Mitigation of Biasness

Investors should be made aware about research

and contemplate investment decision before

executing them.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.classifying objects and thoughts.


Two primary interpretation of representative

bias apply to the individual investors

Base rate Neglect

Sample Size 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- 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 Money illusion: It refers to the tendency of people to think of

currency in nominal, rather than real, terms.

An economic anomaly occurs when there is a

difference between how standard economic

theory predicts people should behave and

how people actually behave.

Anomalies- Economic Behavior

how people actually behave.

Anomalies found in financial literature

Disposition Effect

Endowment bias

In equity reversion

Reciprocity 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.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 self-

esteem 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 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 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 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 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 unexpected gain to feel like the gains are free

money to play with.


It makes us throw more good money after

money already gone bad.

People have strong misgiving about wasting

resources ( Loss Aversion)

Sunk cost fallacy

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. 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.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 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: 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.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 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. 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 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 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 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.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 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.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.method of action.

Thomas Bailard, David Biehl and Ronal Kaiser

provided a graphic representation of their

model.


Straight arrow

CONFIDENT

adventurerindividualistic

CAREFUL IMPETUOUS

Bailard, Biehl and Kaiser 5 way model

Straight arrow

celebrity

ANXIOUS

guardian

CAREFUL IMPETUOUS

Five investors personality types

The Adventurer

The Celebrity

The Individualist

The Guardian 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 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 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 Risk tolerance Investment

style

Decision

making

Passive low Conservative EmotionalPassive

preserver

low Conservative Emotional

Friendly

follower

Cognitive

Independent

individualistic

Cognitive

Active

accumulator

High aggressive Emotional

The common emotional biases exhibited

Passive Preserver: Endowment, Loss aversion,

Status Quo and Regret Aversion

Friendly Follower: Regret Aversion

Independent Individualist: Over confidence, 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,

FramingFraming

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 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 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 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 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 Emotional Bias

High Wealth/ Low SLR Modest Change

+/- 5 to 10% maximum per

asset class

Large Change

+/- 10 to 15% maximum

per asset class

Low Wealth/ High SLR Almost no deviation


asset class

Modest Change


asset class


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.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 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.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.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.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 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 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.Pankaj Mathpal, CFP, CWM, CIWM, CPFA

Technical - hard facts - numbers - lead this type of investor to

active trading based on price movements. They are screen-

watchers, 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 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 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 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 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 MathpalCFPCM, CWM, CIWM, CPFA

www.optimamoney.com

[email protected]@optimamoney.com

facebook.com/optimamoney

twitter.com/pankajmathpal

linkedin.com/pankajmathpal


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Behavioral Finance