Evolving Trends in

BEHAVIORAL FINANCE

For MS in Finance
By: Dr Ikram Ullah Khan
Assistant Professor
IMS, UST Bannu

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Richard H. Thaler is one of the most important economists of our era. His work on behavioral
economics reshaped economics and had far reaching implications for public policy which earned him
the Nobel Prize in Economics in December 2017.
Affiliation at the time of the award: University of Chicago, Chicago, IL, USA
One of his Books
Misbehaving: The Making of Behavioral Economics.

What is behavioral finance?

According to conventional financial theory, the world and its participants are, for the most part,
rational "wealth maximizers". However, there are many instances where emotion and psychology
influence our decisions, causing us to behave in unpredictable or irrational ways. Behavioral finance
is a relatively new field that seeks to combine behavioral and cognitive psychological theory with
conventional economics and finance to provide explanations for why people make irrational financial
decisions.

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A big picture of Behavioral Finance
Behavioral finance, commonly defined as the application of psychology to finance, has become a
very hot topic, generating new credence with the rupture of the tech-stock bubble in March of 2000.
Additional confusion may arise from a proliferation of topics resembling behavioral finance, at least
in name, including behavioral science, investor psychology, cognitive psychology, behavioral
economics, experimental economics, and cognitive science.
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.
Irrational Exuberance, by Yale University professor Robert Shiller, Ph.D
Another high-profile behavioral finance proponent, Professor Richard Thaler, Ph.D., of the University
of Chicago Graduate School of Business.
He explained the irrational investor behavior. 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.
One of the leading authorities on behavioral finance is Professor Hersh Shefrin, Ph.D., a professor of
finance at the Leavey School of Business at Santa Clara University in Santa Clara, California. Professor
Shefrin’s highly successful book Beyond Greed and Fear: Understanding Behavioral Finance and the
Psychology of Investing (Harvard Business School Press, 2000), also forecast the demise of the asset
bubble.
Two more academics, Andrei Shleifer, Ph.D., of Harvard University, and Meir Statman, Ph.D., of the
Leavey School of Business, Santa Clara University, have also made significant contributions.
Professor Shleifer published an excellent book entitled Inefficient Markets: An Introduction to
Behavioral Finance (Oxford University Press, 2000), which is a must-read for those interested
specifically in
Statman has authored many significant works in the field of behavioral finance, including an early
paper entitled “Behavioral Finance: Past Battles and Future Engagements,”4 which is regarded as
another classic in behavioral finance research. His research posed decisive questions: What are the
cognitive errors and emotions that influence investors? What are investor aspirations? How can
financial advisors and plan sponsors help investors? What is the nature of risk and regret? How do

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investors form portfolios? How important are tactical asset allocation and strategic asset allocation?
What determines stock returns? What are the effects of sentiment? Statman produces insightful
answers on all of these points.
Perhaps the greatest realization of behavioral finance as a unique academic and professional
discipline is found in the work of Daniel Kahneman and Vernon Smith.

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.
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 that behavioral models may explain.
Each of the two subtopics of behavioral finance corresponds to a distinct set of issues within the
standard finance versus behavioral finance discussion. With regard to BFMA, the debate asks: Are
markets “efficient,” or are they subject to behavioral effects? With regard to BFMI, the debate asks:
Are individual investors perfectly rational, or can cognitive and emotional errors impact their
financial decisions?

THE TWO GREAT DEBATES OF STANDARD FINANCE VERSUS BEHAVIORAL FINANCE

Two basic concepts in standard finance that behavioral finance disputes:

Rational markets and
Rational economic man
On Monday, October 18, 2004, a very significant article appeared in the Wall Street Journal. Eugene
Fama, one of the pillars of the efficient market school of financial thought, was cited admitting that
stock prices could be-come “somewhat irrational.
The Journal article also featured remarks by Roger Ibbotson, founder of Ibboston Associates: “There
is a shift taking place,” Ibbotson observed. “People are recognizing that markets are less efficient
than we thought.
Standard finance is the body of knowledge built on the pillars of the arbitrage principles (Arbitrage is
buying a security in one market and simultaneously selling it in another at a higher price, profiting
from the temporary difference in prices) of Miller and Modigliani, the portfolio principles of
Markowitz, the capital asset pricing theory of Sharpe, Lintner, and Black, and the option-pricing

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theory of Black, Scholes, and Merton.”8 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. Behavioral finance, like standard finance, is
ultimately governed by basic precepts and assumptions. However, standard finance grounds its
assumptions in idealized financial behavior; be-havioral finance grounds its assumptions in observed
financial behavior.

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 where he persuasively demonstrated that in a securities market populated by many
well-informed investors, investments will be appropriately priced and will reflect all available
information.

There are three forms of the efficient market hypothesis:

Weak-form efficiency: Current prices fully reflect the historical sequence of prices. In short, knowing
past price patterns will not help you improve your forecast of future prices.
Semi-strong form efficiency: Current prices fully reflect all publicly available information, including
such things as annual reports and news items.
Strong-form efficiency: Current prices fully reflect all information, both public and private (i.e.,
information known only to insiders).

An efficient market can basically be defined as a market wherein large numbers of rational investors
act to maximize profits in the direction of individual securities. A key assumption is that relevant
information is freely available to all participants.
The market efficiency debate has inspired literally thousands of studies attempting to determine
whether specific markets are in fact “efficient.” Many studies do indeed point to evidence that
supports the efficient market hypothesis. Researchers have documented numerous, persistent
anomalies, however, that contradict the efficient market hypothesis.
There are three main types of market anomalies: Fundamental Anomalies, Technical Anomalies, and
Calendar Anomalies.

1. Fundamental Anomalies
Irregularities that emerge when a stock’s performance is considered in light of a fundamental
assessment of the stock’s value are known as fundamental anomalies. Many people, for example,
are unaware that value investing—one of the most popular and effective investment methods—is
based on fundamental anomalies in the efficient market hypothesis. There is a large body of
evidence documenting that investors consistently overestimate the prospects of growth companies
and underestimate the value of out-of-favor companies.

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 2. Technical Anomalies:
Another major debate in the investing world revolves around whether past securities prices can be
used to predict future securities prices. “Technical analysis” encompasses a number of techniques
that attempt to forecast securities prices by studying past prices. Sometimes, technical analysis
reveals inconsistencies with respect to the efficient market hypothesis; these are technical
anomalies. Common technical analysis strategies are based on relative strength and moving
averages, as well as on support and resistance.

3. Calendar Anomalies:
One calendar anomaly is known as “The January Effect.” Historically, stocks in general and small
stocks in particular have delivered abnormally high returns during the month of January. Robert
Haugen and Philippe Jorion, two researchers on the subject, note that “the January Effect is,
perhaps, the best-known example of anomalous behavior in security markets throughout the
world”. The January Effect is particularly illuminating because it hasn’t disappeared, despite being
well known for 25 years (according to arbitrage theory, anomalies should disappear as traders
attempt to exploit them in advance).

Rational Economic Man versus Behaviorally Biased Man:

Stemming from neoclassical economics, Homo economicus is a simple model of human economic
behavior, which assumes that principles of perfect self-interest, perfect rationality, and perfect
information govern economic decisions by individuals. Like the efficient market hypothesis, Homo
economicus is a tenet that economists uphold with varying degrees of stringency.

Some have adopted it in a semi-strong form; this version does not see rational economic behavior as
perfectly predominant but still assumes an abnormally high occurrence of rational economic traits.
Other economists support a weak form of Homo economicus, in which the corresponding traits exist
but are not strong. All of these versions share the core assumption that humans are “rational
maximizers” who are purely self-interested and make perfectly rational economic decisions.

Most criticisms of Homo economicus proceed by challenging the bases for these three underlying
assumptions—perfect rationality, perfect self-interest, and perfect information.
1.Perfect Rationality. When humans are rational, they have the ability to reason and to make
beneficial judgments. However, rationality is not the sole driver of human behavior. Human behavior
is less the product of logic than of subjective impulses, such as fear, love, hate, pleasure, and pain .
2.Perfect Self-Interest
Many studies have shown that people are not perfectly self-interested. If they were, philanthropy
would not exist. Religions prizing selflessness, sacrifice, and kindness to strangers would also be
unlikely to prevail as they have over centuries. Perfect self-interest would preclude people from
performing such unselfish deeds as volunteering, helping the needy, or serving in the military. It
would also rule out self-destructive behavior, such as suicide, alcoholism, and substance abuse.
3. Perfect Information
Some people may possess perfect or near-perfect information on certain subjects; a doctor or a
dentist, one would hope, is impeccably versed in his or her field. It is impossible, how-ever, for every
person to enjoy perfect knowledge of every subject. In the world of investing, there is nearly an
infinite amount to know and learn; and even the most successful investors don’t master all
disciplines.

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Many economic decisions are made in the absence of perfect information. For instance, some
economic theories assume that people adjust their buying habits based on the Federal Reserve’s
monetary policy.
Naturally, some people know exactly where to find the Fed data, how to interpret it, and how to
apply it; but many people don’t know or care who or what the Federal Reserve is.

Again, as with market efficiency, human rationality rarely manifests in black or white absolutes. It is
better modeled across a spectrum of gray. People are neither perfectly rational nor perfectly
irrational; they possess diverse combinations of rational and irrational characteristics, and benefit
from different degrees of enlightenment with respect to different issues.

Theories of Investors’ Behavior

1. Regret-Theory
The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals
might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this
possibility. Regret theory states that people anticipate regret if they make a wrong choice and they
take this anticipation into consideration when making decisions. Fear of regret can play a significant
role in dissuading someone from taking an action or motivating a person to take an action.
When investing, regret theory can either make investors risk averse or it can motivate them to take
greater risks. For example, suppose that an investor buys stock in a small growth company based
only on a friend’s personal recommendation. After six months, the stock falls to 50% of the purchase
price, so the investor sells the stock and realizes a loss. To avoid this regret in the future, the investor
will ask questions and research any stocks that his friend recommends. Conversely, suppose
the investor didn’t take the friend’s recommendation to buy the stock, and the price increased by
50%. To avoid the regret of missing out, the investor will be less risk averse and will likely buy any
stocks that his friend recommends in the future without conducting any background research of his
own.

2. Theory of Mental Accounting

First coined by University of Chicago professor Richard Thaler, mental accounting describes people’s
tendency to code, categorize, and evaluate economic outcomes by grouping their assets into any
number of non-fungible (non-interchangeable) mental accounts.
\Mental accounting refers to the tendency for people to separate their money into
separate accounts based on a variety of subjective criteria, like the source of the money and intent
for each account.
Richard Thaler introduced mental accounting in his 1999 paper "Mental Accounting Matters," which
appeared in the Journal of Behavioral Decision Making. He begins with his definition: "mental
accounting is the set of cognitive operations used by individuals and households to organize,
evaluate and keep track of financial activities." The paper is rich with examples of how mental
accounting leads to irrational spending and investment behavior. Underlying the theory is the
concept of fungibility (substitutability) of money.
Individuals should treat money as perfectly fungible when they allocate among a budget account
(everyday living expenses), discretionary spending account, and a wealth account (savings and
investments).

Some factors for mental accounting;

1.Source of Income and the feeling towards it have impact on spending

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2.Free money/Bonuses/Form changes/
3. Timing
3.Prospect/Loss-Aversion-Theory:
[Investors more risk-adverse in domain of losses than gains]

Prospect theory assumes that losses and gains are valued differently, and thus individuals make
decisions based on perceived gains instead of perceived losses. Also known as “loss-aversion”
theory, the general concept is that if two choices are put before an individual, both equal, with one
presented in terms of potential gains and the other in terms of possible losses, the former option
will be chosen.

For example, consider an investor is given a pitch for the same mutual fund by two separate financial
advisors. One advisor presents the fund to the investor, highlighting that it has an average return of
12% over the past three years. The other advisor tells the investor that the fund has had above-
average returns in the past 10 years, but in recent years it has been declining. Prospect theory
assumes that though the investor was presented with the exact same mutual fund, he is likely to buy
the fund from the first advisor, who expressed the fund’s rate of return as an overall gain instead of
the advisor presenting the fund as having high returns and losses.

4. Over/Under Reacting Theory

A challenge to the efficient market hypothesis is that individuals often over-or under-react to news.
If over-reactions and under-reactions are split randomly, then these biased reactions could still be
consistent with the efficient market hypothesis.
However, psychological factors suggest that there are systematic patterns of over-reaction and
under-reaction. For example, individuals tend to be conservative and rely too much on their prior
beliefs, and hence they under-react to news. On the other hand, information that is salient and
prominent captures people’s attention and becomes more important in the decision making process.
People assign a heavier weight to such information in forming new beliefs, resulting in over-reaction.
Prices can therefore deviate from their fair or rational market value at least temporarily.

5. Theory of Overconfidence:
“Too many people overvalue what they are not and undervalue what they are”.—M.S. Forbes
The overconfidence effect is a well-established bias in which a person's subjective confidence in his
or her judgments is reliably greater than the objective accuracy of those judgments, especially when
confidence is relatively high. Overconfidence is one example of a miscalibration of subjective
probabilities. Throughout the research literature, overconfidence has been defined in three distinct
ways: (1) overestimation of one's actual performance; (2) overplacement of one's performance
relative to others; and (3) overprecision in expressing unwarranted certainty in the accuracy of one's
beliefs.
Overconfidence can be summarized as unwarranted faith in one’s intuitive reasoning, judgments,
and cognitive abilities. The concept of overconfidence derives from a large body of cognitive
psychological experiments and surveys in which subjects overestimate both their own predictive
abilities and the precision of the information they’ve been given.

6. Herding Theory:
Human tendency to follow the crowd leading to decisions that may not have made/taken if alone.
It’s a belief that so many people cannot be wrong. People doing what others do, instead of using
their own information to make decisions.

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Herd behavior describes how individuals in a group can act collectively without centralized direction.
The term can refer to the behavior of animals in herds, bird flocks, fish schools and so on, as well as
the behavior of humans in demonstrations, riots and general strikes, sporting events, religious
gatherings, episodes of mob violence and everyday decision-making, judgment and opinion-forming.

Chapter 3: Emotions and Investment Decisions

Behavioral biases and corporate decision-making

Behavioral biases are defined, abstractly, the same way as systematic errors in judgment.
Researchers distinguish a long list of specific biases, applying over 50 of these to individual investor
behavior in recent studies.

Biases and Heuristics

Some authors refer to biases as heuristics (rules of thumb), while others call them beliefs,
judgments, or preferences; still other scholars classify biases along cognitive or emotional lines. This
sort of bias taxonomy is helpful—an underlying theory about why people operate under bias has not
been produced. Instead of a universal theory of investment behavior, behavioral finance research
relies on a broad collection of evidence pointing to the ineffectiveness of human decision making in
various economic decision-making circumstances.

Heuristics, often referred to as rules of thumb, are means of reducing the search
necessary to find a solution to a problem. They are shortcuts that simplify the complex methods of
assessing the probabilities and values ordinarily required to make judgments, and eliminate the
need for extensive calculation.

The Rationale for Heuristics

 Decision makers may be unaware of the optimal way to solve a problem, even when an ideal
solution exists. Moreover, they may not have the resources (or the access to credit) to
obtain help from others, or the deliberation costs involved may be excessive.
 Decision makers may be unable to obtain all the information necessary for an optimizing
solution, or may not be able to do so by the time a decision must be made. Even if they can
obtain all the information, decision makers may be unable to complete the optimization
calculations in time.
 While optimization techniques may be feasible, they may not yet have been devised for
some types of problems.
 Where there are multiple objectives, unique, optimal solutions are unlikely.
 The use of rules of thumb that decision makers can rapidly apply may enable them to keep
certain matters secret until they decide to make the decision known.
 The problem may not lie in obtaining the information, but in perceiving it correctly and
avoiding attempts to deal with what is actually a variant of the matter under consideration.

 An extraordinary amount of information may overwhelm decision makers. A decision maker

may have insufficient familiarity with the programs necessary to process the data. In
addition, the emotional character of the decision (or the decision maker) might be

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 overwhelming, at least in the context in question. Finally, the state of awareness of decision
makers at the time in question or the particular framing of the problem may pose issues.

 Tversky and Kahneman (1982a) argue for the prevalence of three general-purpose
heuristics: representativeness, availability, and anchoring and adjustment. Later, Slovic,
Finucane, Peters, and MacGregor (2002) bring together the work of many other researchers
and explicitly include emotional factors as a general-purpose heuristic under the term the
affect heuristic. Gilovich and Griffin (2002) list six general-purpose heuristics: affect,
availability, causality, fluency, similarity, and surprise.

 This chapter focuses on the four heuristics noted by Kahneman, Slovic and Tversky (1982)
and Slovic et al. (2002), namely, representativeness, availability, anchoring and adjustment,
and affect.

1.Representativeness [information processing error ]

Representativeness involves judgments of the likelihood of an event or identification, based on its

similarity to a class of events or individuals. As with the other general heuristics, there are no
uniform guidelines on the degree to which representativeness affects judgments of likelihood.
In financial markets, one example of this representative bias is when investors automatically assume
that good companies make good investments. However, that is not necessarily the case. A company
may be excellent at their own business, but a poor judge of other businesses.

2.Availability

The availability bias 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 appears in their lives.
People exhibiting this bias perceive easily recalled possibilities as being more likely than those
prospects that are harder to imagine or difficult to comprehend. In sum, the availability rule of
thumb underlies judgments about the likelihood or frequency of an occurrence based on readily
available information, not necessarily based on complete, objective, or factual information.

Availability is the heuristic reflecting the weight given to information in place of probability or
frequency. That weighting is attributable to the ease of recall and the content of what is re-called.
Availability may be due to some recent dramatic news event. In general, as Warneryd (2001) notes,
availability can be experience-based, memory-based, or imagination-based. Unfortunately, there is
no agreement as to what constitutes different degrees of availability or the weight that should be
given to those differences in availability.

3.Anchoring and Adjustment

When required to estimate a value with unknown magnitude, people generally begin by envisioning
some initial, default number—an “anchor”—which they then adjust up or down to reflect
subsequent information and analysis.
Anchoring and adjustment is a heuristic that involves adjustment from some starting point. The
starting point may refer to recent data such as the current rate of inflation or economic growth, but
often, the relevant starting point is much less known to those who make judgments. Indeed, the

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anchor may involve random data and even false data deliberately injected by individuals serving as
“plants” hired by the organizers of experiments to respond with irrelevant numbers. Such situations
affect the results of isolated experiments in a major way, but whether the results are indicative of
what happens in many types of real-life situations is unclear.

Suppose you are asked whether the population of Canada is greater than or less than 20 million.
Obviously, you will answer either above 20 million or below 20 million. If you were then asked to
guess an ab-solute population value, your estimate would probably fall somewhere near 20 million,
because you are likely subject to anchoring by your previous response.

Anchoring and adjustment is a psychological heuristic that influences the way people intuit
probabilities. Investors exhibiting this bias are often influenced by purchase “points”—or arbitrary
price levels or price indexes—and tend to cling to these numbers when facing questions like “Should
I buy or sell this security?” or “Is the market overvalued or undervalued right now?” This is especially
true when the introduction of new information regarding the security further complicates the
situation. Rational investors treat these new pieces of information objectively and do not reflect on
purchase prices or target prices in deciding how to act. Anchoring and adjustment bias, however,
implies that investors perceive new information through an essentially warped lens. They place
undue emphasis on statistically arbitrary, psychologically determined anchor points. Decision making
therefore deviates from
Neo classically prescribed “rational” norms.

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