BEHAVIOURAL FINANCE

CHAPTER 1 – INTRODUCTION TO BEHAVIORAL FINANCE

Rational and Irrational Behavior
 Traditional v/s Behavioral Finance

► TRADITIONAL (standard) FINANCE

►Investors & Markets are --- rational

►They use to gather all the information they need & their decision based on the data

►They don’t make financial decision on emotions

►Investors not able to exploit the market no will get abnormal gain and loss

► BEHAVIOURAL FINANCE

►Psychology has a role in how people use to take financial decisions

►People are irrational & our emotions & bias have a role in decision making
Rationality and irrationality
 Rational v/s Irrational

► Rational behavior is a trait of an individual whose decisions

are based on sensible reasoning.
► Irrational behavior is the behavior of an individual who favors
emotion and disregards logic and reasoning.
► Rationally behaving involves considering options and
weighing their cost and benefit.
 Behavioral Finance Role in Investment

► Efficient Market Hypothesis

► (EMH) argues that markets are efficient, leaving no room to make excess profits by investing
since everything is already fairly and accurately priced. This implies that there is little hope of
beating the market, although you can match market returns through passive index investing.
► Can Markets Be Inefficient?
► Market information asymmetries,
► a lack of buyers and sellers (i.e. low liquidity),
► high transaction costs or delays,
► market psychology, and
► Human emotion,
 Meaning

► Behavioral finance is a relatively new school of thought that

deals with the influence of psychology on the behavior of
financial practitioners and its subsequent impact on stock
markets (Sewell, 2007).
► It signifies the role of psychological biases and their specific
behavioral outcome in decision making.
 What BF does?

► Behavioral finance uses financial psychology to

analyze investors' actions.
► According to behavioral finance, investors aren’t
rational. Instead, they have cognitive biases and
limited self-control that cause errors in judgment.
 History of Behavioural Finance

► The concept of behavioral finance dates to 1912 when George

Seldon published “Psychology of the Stock Market.”
► However, the theory gained popularity and momentum in 1979
► When Daniel Kahneman and Amos Tversky proposal
► Richard Thaler introduced the notion of “mental accounting,”
► The study of cognitive psychology and behavioral biases in
finance.
 Applications of bf

► An individual
► An institution
► A corporate
► A market
 Understanding – Behavioral Finance

► The wealth nation - 1776 – Adam Smith

► “Fuller and Thaler Asset Management Company
► The big short - movie
 The wealth of Nations - 1776

► The Wealth of Nations, work by the Scottish economist and philosopher

Adam Smith, first published in 1776.
► The Theory of Moral Sentiments. Didactic, exhortative, and analytic by
turns, it lays the psychological foundation on which The Wealth of Nations
was later to be built.
► In it Smith described the principles of “human nature,” which, together
with Hume and the other leading philosophers of his time, he took as a
universal and unchanging datum from which social institutions, as well as
social behavior, could be deduced.
Richard Thaler

► Thaler was the 2017 recipient of the Nobel Memorial

Prize in Economics for "incorporating psychologically
realistic assumptions into analyses of economic
decision-making.
► By exploring the consequences of limited
rationality, social preferences, and lack of self-control,
he has shown how these human traits systematically
affect individual decisions as well as market outcome
`
 Robert Shiller

► In March 2000, Robert Shiller published his soon-to-be

bestseller “Irrational Exuberance.”
► The timing was perfect. That very month, the dot-com bubble
burst just as Shiller had predicted in his book.
► The Yale professor was thrust into the spotlight and stayed
there. He was right a second time when he warned of a
collapse of the American housing market, long before prices
actually dropped.
► Shiller has been a celebrity economist ever since.
 Shiller story

► Shiller is one of the founders of behavioral economics,

behavioral finance in particular.
► He, along with two other economists, Daniel
Kahneman and Richard Thaler, are leading figures who
created a new approach that profoundly challenged existing
thinking.
► For decades, they’ve emphasized the importance of taking a
broader view and incorporating other academic disciplines
into economics
Daneil Kahneman

► Daniel Kahneman, (born March 5, 1934, Tel Aviv, Palestine

[now Tel Aviv–Yafo, Israel]), Israeli-born psychologist,
corecipient of the Nobel Prize for Economics in 2002 for his
integration of psychological research into economic science.
► His pioneering work examined human judgment and decision
making under uncertainty.
Understanding – Behavioral Finance

► “Shiller and Thaler Asset Management Company” Assumes that

investors will capitalize the “Cognitive Bias”
► Cognitive Bias is a systematic pattern of deviation from Norm or
rationality
► Individuals create their own subjective reality from their perception of
the input
► Cognitive Bias has
► Endowment effect – WTP & WTA
► Loss aversion
► Status quo bias ( psychological inertia).
 Financial Psychology

► Financial psychology explores the reasons behind

individuals’ financial decisions, considering
cognitive, social, emotional, and cultural factors.
► Behavioral finance combines psychological
theories with traditional economic concepts,
revealing that investors aren’t perfectly rational but
are influenced by cognitive biases and emotions,
leading to suboptimal decisions.
 Human Psychology

► Behavioral investing is a subsection within the larger discipline of

behavioral finance that focuses on the influence of human
psychology on behaviors related to investing and financial
management.
► This subgroup aims to establish a connection between psychology
and investment by examining the biases that investors face,
comprehending how these biases appear
► The investment process, encourages the individuals to adopt a
skeptical, scientifically based approach to their investment plans.
 Behavioral Finance Concepts

1. Bounded Rationality:
► Bounded rationality states that individuals operate within limitations such as cognitive resources,
time, and information when making decisions.
2. Heuristics:
► Heuristics, identified as mental shortcuts, serve as tools individuals use to make quick and
efficient decisions.
3. Prospect Theory:
► Developed by Amos Tversky and Daniel Kahneman, prospect theory stands as a foundation for
behavioral finance. It proposes that individuals assess financial outcomes based on gains and
losses relative to a reference point rather than considering final wealth levels.
4. Mental Accounting:
► Mental accounting, introduced by Richard Thaler, involves individuals categorizing and
evaluating financial transactions within separate mental accounts.
 Continued…………………….

5. Overconfidence:
► Overconfidence, a cognitive bias, leads individuals to overestimate their knowledge, skills, or
ability to predict future outcomes.
6. Confirmation Bias:
► Confirmation bias involves seeking, interpreting, and remembering information that aligns with
pre-existing beliefs while dismissing contradictory evidence.
7. Anchoring:
► Anchoring represents the inclination of people to heavily rely on the initial piece of information
encountered while deciding investment.
8. Loss Aversion:
► Loss aversion highlights individuals’ preference for avoiding losses over acquiring equivalent gains.
 Continued……………

9. Herding Behavior:
► Herding behavior reflects individuals’ tendency to follow the actions or
beliefs of a larger group, even if they contradict their own judgment or
available information.
10. Availability Bias:
► Availability bias involves relying on readily available information or
recent experiences when making decisions.
 Why Behavioral Finance Matters?

• It enables them to identify and correct

their illogical preferences while making
financial decisions.
• It explains typical illogical behaviors,
such as panic selling during market
downturns or overspending,
• It studies patterns of decision-making.
• It emphasizes the human aspect of
finance, highlights the value of
emotional self-control.
 Expected utility Theory

► The expected utility refers to a theory summarizing the utility that one expects an aggregate
economy or entity to reach irrespective of different circumstances. Individuals utilize it as a tool
to analyze situations where they have to make decisions without being aware of the possible
outcomes.
► Expected Utility:
 Expected Utility theory

► Economic issues, such as costs and benefits, are also commonly claimed to be factors in a person's
decision-making process.
► For example, lack of financial resources has been cited as a reason for software piracy behavior.
Expected utility theory (EUT) posits that, when faced with an array of risky decisions, an individual will
choose the course of action that maximizes the utility (benefits minus costs) to that individual.
► In most cases, computer-using professionals have three possible courses of action, when faced with
a situation in which software can be used:
► purchase the software, do without the software, or pirate the software. It is possible to describe these
choices in terms of EUT. To do so, it is necessary to determine the costs and benefits involved.
► However, a purchase cost is involved, if the software is legally obtained. The expected utility of
purchasing the software is the expected benefit gained from the use of the software, less the
expected cost of the software.
 Continued…………..

► The expected utility refers to an event or action’s utility over a certain

duration under any circumstance. This concept facilitates
decision-making when there is uncertainty.
► According to this theory, people will select the event or action with the
maximum expected utility, which one can obtain by summing up the
products of utility and probability over every possible outcome.
Individuals’ decision depends on their risk aversion and other agents’
utility.
► It is derived from the expected utility theory, a hypothesis stating that
the weighted average of every possible utility level will best depict utility
at any point in time under uncertainty.
 How To Calculate?

► To calculate expected utility, individuals must multiply the agent’s value of every plausible
outcome of the event or action by the probability of the outcome materializing.
► After that, they must compute the sum of those numbers.

For example:-

Suppose an individual named Sam purchases a lottery ticket.

In this case, there are two potential outcomes – he may lose the full amount spent to
make the purchase, or he might make a profit if he wins the lottery partially or fully.

After assigning probability values to the associated costs, which in this case, is the lottery
ticket’s cost price, it is easy to find that the expected utility one can obtain from buying
the ticket is more than not purchasing it.
 Continued……………..

► This utility theory has application in public policy because it elucidates

that the social arrangement maximizing the overall welfare throughout
society is the most accurate.
► The use of expected utility in behavioral finance is also popular for
guiding health insurance plans.
► Moreover, insurance sales involve utilizing this theory to compute risks
with the objective of long-term financial gain while considering the
chance of going bust for a limited period.
Advantages

► It is the concept reflects how individuals value outcomes

differently based on their risk appetite.
► The concept can offer a normative framework for the purpose
of rational decision-making. This means it can specify what
individuals must do to fulfill their objectives, given their beliefs
and preferences.
► It can handle dynamic and complex decisions where
outcomes depend on various factors and uncertain and
interrelated events.
 Disadvantages

► Measuring and eliciting the probability and utility values required to

apply this theory can be challenging. This is because individuals may not
have consistent or well-defined preferences over outcomes. Or, they
may fail to express their preferences in numerical terms.
► The theory can be impractical or unrealistic in a few situations where
transitivity, rationality, and completeness assumptions may not hold.
► Other models or theories may modify or challenge this theory by better
predicting or explaining human behavior under uncertain
circumstances.
 Expected Utility vs Expected Value

► Expected utility and value can be confusing, especially for individuals new to the field of
economics. However, they can understand their meaning and avoid confusion by learning
about their vital differences.

Expected Utility Expected Value

It is the utility of any action over a specific term Expected value refers to an anticipated average
where one is unaware of the circumstances. value.

It facilitates decision-making and analyzing Investors use it to estimate investments’

situations where there is uncertainty concerning worthiness, often with reference to their relative
the outcome. riskiness.
 How to maximize expected utility?

► One can maximize it by increasing the probabilities.

► Maximizing this utility means choosing the option yielding
the maximum average utility.
► In this case, the average utility is all utilities’
probability-weighted sum.
► This theory needs individuals to be aware of every
outcome’s probability.
 Who created the expected utility theory?

► Daniel Bernoulli was the first to posit this theory in the

18th century.
► In 1738, he was able to resolve the St. Petersburg
Paradox (the reason why individuals were willing only
to make a small payment for a high-risk gamble with
infinite anticipated monetary value) using the
hypothesis.
 Is expected utility theory useful?

► It offers a way of ranking the events or actions based on how

choice worthy they are.
► One must remember that the higher this utility, the better it is
for one to select the event or action.
► Thus, choosing the act that has the highest utility is the best
decision.
► In the event of a tie among several acts, one can select any
one.
 Risk-neutral expected utility?

► What is If the utility of an individual’s

anticipated value of a gamble is the
same as its expected utility, it is
risk-neutral.
THANK YOU