Behavioral Finance-An Overview

Today’s Contents
• Course overview and group formation
• Interaction about previous knowledge on risk and
return
• Discuss on how they make decision on share trading
• CAPM discussion
• APT discussion
• Perfect market and prerequisites
• Need of behavioral finance
• Terms in behavioral finance
• Article for reading
“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.
 Behavioral Finance
Use psychology and economics to understand finance:

Asset pricing: Corporate finance: Personal finance:

• Price Anomalies • IPO timing • Procrastination

• IPO underperformance • Winner’s curse • Emotional choice
•Sentiment • Cash-flow sensitivity • Loss aversion
• Equity premium • Overconfidence • Narrow Framing
• PEA drift • Superstar CEO’s • Return chasing
• Momentum : riding "hot" • Passivity
stocks and selling "cold" • Financial illiteracy
ones • Home bias
• Bubbles • Overconfidence
• Wishful thinking
 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 earn higher rates of
returns compared to less risky firms

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 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

9
 An Introduction to Behavioral
Finance
• Behavioral finance theory rests on the following three
assumptions/characteristics
• Investors exhibit information processing biases that cause
them to over- and under-react
• Individual investors’ errors/biases in processing information
must be correlated across investors so that they are not
averaged out
• Limited arbitrage: Existence of rational investors should not
be sufficient to make markets efficient

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Behavioral finance theories

• 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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Behavioral finance theories

• 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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 Behavioral finance theories

• 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 underreaction 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

13
 Behavioral finance theories

• Human information processing biases

• Investor 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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 Behavioral finance theories

• 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

• 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 subject to similar biases
• Experimental psychology literature confirms systematic biases among
people

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 Behavioral finance theories

• Limited arbitrage
• Efficient markets theory is predicated 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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 Behavioral finance theories

• 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
• Holding costs: Duration of the arbitrage and cost of short selling
• Information costs: Information acquisition, analysis and monitoring

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 Behavioral finance theories

• 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 (the book)
• 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 can we 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 Conti…
 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 Conti…
 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- vindication of 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
Cognitive psychology
(When markets will be
(How people think?)
inefficient?)
 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
o 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.
o 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

correctly. thumb (heuristics) 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
transparent and objective lens of risk and significantly influenced by how decisions
return (inconsequential frame definition). problems are framed (frame dependence).

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

4. Markets are efficient. Market price of 4. Heuristic-driven biases and errors,

each security is an unbiased estimate of frame dependence, and effects of
its intrinsic value. emotions and social influence often lead
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 Conti…
 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 stark 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 Conti…
• 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:
o Greed
o Fear
o Expectations, and
o 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.
 Personality Traits and Risk Profile Influencing
Attitude of Investor

 The five factor model delineates five broad traits:

Personality Traits and Risk
Profile of Investors

Extraversion Neuroticism Openness

Agreeableness Conscientiousness
To experience

 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 Conti…
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 uncooperative, 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
 Personality Traits and Risk Profile Influencing Attitude of
Investor Conti…
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.
 Literature Review-Behavioral Finance
• Gustave le Bon (1896) Wrote ‘The Crowd: A Study of the
Popular Mind’, one of the greatest and most influential books
of social psychology ever written.
• Selden (1912) wrote ‘Psychology of the Stock Market’. He
based the book ‘upon the belief that the movements of prices
on the exchanges are dependent to a very considerable degree
on the mental attitude of the investing and trading public’.
• In 1956 the US psychologist Leon Festinger introduced a new
concept in Social psychology: the theory of cognitive
dissonance (Festinger, Riecken and Schachter, 1956). When
two simultaneously held cognitions are inconsistent, this will
produce a state of cognitive dissonance. Because the
experience of dissonance is unpleasant, the person will strive to
reduce it by changing their beliefs.
 Literature Review-Behavioral Finance
Conti…
• Pratt (1964) considers utility functions, risk aversion and
also risks considered as a proportion of total assets.
• Tversky and Kahneman (1973) introduced the
availability heuristic: ‘a judgmental heuristic’ in which a
person evaluates the frequency of classes or the probability
of events by availability, i.e. by the ease with which
relevant instances com to mind’. The reliance on the
availability heuristic leads to systematic biases.
• In 1974, two brilliant psychologists, Amos Tversky and
Daniel Kahneman, described three heuristics that are
employed when making judgements under uncertainty
(Tversky and Kahneman, 1974): representativeness,
availability, and anchoring and adjustment.
 Literature Review-Behavioral Finance
Conti…
• In another important paper Tversky and Kahneman
(1981) introduced framing. They showed that the
psychological principles that govern the perception of
decision problems and the evaluation of probabilities and
outcomes produce predictable shifts of preference when
the same problem is framed in different ways.
• Shiller (1981) discovered that stock market volatility is
far too high to be to new information about future real
dividends.
• Kahneman, Slovie, and Tversky (1982) edit Judgement
Under Uncertainty: Heuristics and Biases, which
describe various judgmental heuristics and the biases
they produce.
 Literature Review-Behavioral Finance
Conti…
• In 1985 Werner F. M. De Bondt and Richard Thaler published
‘Does the stock market overreact?’ in The Journal of Finance.
They discovered that people systematically overreacting to
unexpected and dramatic news events results in substantial weak-
form inefficiencies in the stock market.
• Thaler (1985) developed a new model of consumer behavior
involving mental accounting which is the set of cognitive
operations used by individuals and households to organize,
evaluate, and keep track of financial activities.
• Tversky and Kahneman (1986) argue that, due to framing and
prospect theory, the rational theory of choice does not provide an
adequate foundation for a descriptive theory of decision making.
• Yaari (1987) proposes a modification to expected utility theory and
obtains a so-called ‘dual theory’ of choice under risk. De Bondt
and Thaler (1987) report additional evidence that supports the
overreaction hypothesis.
 Literature Review-Behavioral Finance
Conti…
• Samuelson and Zeckhauser (1988) perform a series of decision-
making experiments and find evidence of status quo bias.
• Kahneman, Knetsch and Thaler (1990) report several
experiments that demonstrate that Loss aversion and the
endowment effect persist even in market settings with opportunities
to learn and conclude that they are fundamental characteristics of
preferences.
• Gilovich (1991) wrote How We Know What Isn’t So, a book about
the fallibility of human reason in everyday life.
• Fernandez and Rodrik (1991) model an economy and show how
uncertainty regarding the identities of gainers and losers can lead
to status quo bias. Kahneman, Knetsch and Thaler (1991)
discuss three anomalies: the endowment effect, loss aversion, and
status quo bias. Banerjee (1992) develop a simple model of herd
behavior.
• Plous (1993) wrote ‘The Psychology of Judgement and Decision
Making’ which gives a comprehensive introduction to the field with
a strong focus on the social aspects of decision making processes.
 Literature Review-Behavioral Finance
Conti…
• A value strategy involves buying stocks that have low prices
relative to earnings, dividends, book assets, or other measures
of fundamental value.
• Lakonishok, Shleifer and Vishnty (1994) conjecture that
value strategies yield higher returns because these strategies
exploit the suboptimal behavior of the typical investor.
• The equity premium puzzle refers to the empirical fact that
stocks have outperformed bonds over the last century by a far
greater degree than would be expected under the standard
expected utility maximizing paradigm.
• Grinblatt, Titman and Wermers (1995) analyzed the
behavior of mutual funds and found evidence of momentum
strategies and herding.
• Chan, Jagadeesh and Lakonishok (1996) found that both
price and earnings momentum strategies were profitable,
implying that the market responds only gradually to new
information, i.e. there is underreaction.
 Literature Review-Behavioral Finance
Conti…
• Basu (1997) finds evidence for the conservatism principle, which he
interprets as earnings reflecting ‘bad news’ more quickly than ‘good
news’.
• Barberis, Shleifer and Vishny (1998) present a model of investor
sentiment that displays underreaction of stock prices to news such as
earnings announcements and overreaction of stock prices to a series
of good or bad news.
• Odean (1998) tested and found evidence for the disposition effect,
the tendency of investors to sell winning investments too soon and
hold losing investments for too long.
• Daniel, Hirshleifer and Subrahmanyam (1998) propose a theory
of security markets based on investor overconfidence (about the
precision of private information) and biased self-attribution (which
causes changes in investors’ confidence as function of their
investment outcomes) which leads to market under and
overreactions. Camerer and Lovallo (1999) found experimentally
that overconfidence and optimism lead to excessive business activity.
 Literature Review-Behavioral Finance
Conti…
• There is a commonly observed but unexpected negative correlation
between perceived risk and perceived benefit. Finucane, et. al.
(2000) concluded that this was due to the affect heuristic-people
tend to derive both risk and benefit evaluations from a common
source.
• Shefrin (2000) wrote ‘Beyond Greed and Fear’, an excellent book
on behavioral finance and the psychology of investing.
• Lee and Swaminathan (2000) showed that past trading volume
provides an important link between ‘momentum’ and ‘value’
strategies and these findings help to reconcile intermediate-horizon
‘underreaction’ and long-horizon ‘overreaction’ effects.
• Psychological research has established that men are more prone to
overconfidence than women (especially in male-dominated areas
such as finance), whilst theoretical models predict that
overconfident investors trade excessively. Barber and Odean
(2001) found that men trade 45 per cent more than women and
thereby reduce their returns more so than women and conclude that
this is due to overconfidence.
 Literature Review-Behavioral Finance
Conti…
• Barberis, Huang and Santos (2001) incorporate
prospect theory in a model of asset prices in an economy.
• Grinblatt and Keloharju (2001) identify the
determinants of buying and selling activity and find
evidence that past returns, reference price effects, tax-loss
selling and the fact that investors are reluctant to realize
losses are all determinants of trading.
• Huberman (2001) provide compelling evidence that
people have a propensity to invest in the familiar, while
often ignoring the principles of portfolio theory.
 Literature Review-Behavioral Finance
Conti…
• Gilovich and Griffin (2002) identify six general purpose
heuristics (affect, availability, causality, fluency, similarity, and
surprise) and six special purpose heuristics (attribution,
substitution, outrage, prototype, recognition, choosing by liking and
choosing by default), whilst two heuristics have been superseded
(representativeness (replaced by attribution-substitution (prototype
heuristic and similarity heuristic)) and anchoring and adjustment
(replaced by the affect heuristic).
• Holt and Laury (2002) conducted a simple lottery choice
experiment and found differences in risk aversion between behavior
under hypothetical and real incentives.
• Barberis and Thaler (2003) publish a survey of behavioral finance.
More recent developments in decision making under risk have
improved upon cumulative prospect theory, such as the transfer of
attention exchange model (Birnbaum, 2008).
• Harrison and Rutstrom (2009) proposed a reconciliation of
expected utility theory and prospect theory by using a mixture
model.
Thanking You