Behavioural Finance?

 Root: Behavioral economics

 Meaning:
 uses psychological theories in understanding
and explaining the investor behaviour.
 (behavioral + psychological theories) +
conventional finance
 tries to fill the gap b/w actual behavior (normal
behaviour) and expected behaviour (rational
behaviour)
 Context: investment decisions under risk and
uncertainty
Risk Nature of Investors
Risk Averse-Diminishing Marginal Utility
Risk Loving- Increasing Marginal Utility
Risk Neutral- Constant Marginal Utility
BEHAVIOURAL FINANCE

EXPECTED UTILITY THEORY

And
PROSPECTS THEORY
 Expected Utility Theory
Breaking Down
• Developed by- Daniel Bernoulli(1738); John Von
Neumann and Oskar Morgenstern
• Association: Associated with Standard Finance
• Usage: Descision making Under Risk and
Uncertainity
• Stage: Existence of multiple possible outcomes
and varying degree of probabilities
(Gambles/Lotteries/Prospects)
• Feature of stage: Each alternative has an
expected utility which is the sum of the product
of the probability and utility over possible
outcome.
 Expected Utility Theory
Breaking Down (Contd…)
• Individual makes a decision of choosing a
particular course of action which will result in
highest utility.
• Expected Utility Theory is a theory of utility
in which betting preferences of people with
regard to uncertain outcome ( Gambles) are
represented through a function of the payout
and probabilities( i.e expected utility) and
people prefer one which offers highest utility.
 Expected Value and Expected Utility
• Gamble:
Option A: 90% chance of $100; 10% chance of getting 0
• Option B: 20% chance of $500 and 80% chance of
getting 0
• EV of A= p(A) X V (A) + P(A’) X V(A’)
• = .9 X 100+ .1 X 0= 90
• EV of B = p(B) X V (B) + P (B’) X V(B’)
• = .2 X 500+ .8 X 0= 100
• EV theory would say that Person 1 should choose B.
 Expected Value and Expected Utility
• Gamble:
Option A: 90% chance of $100; 10% chance of getting 0
• Option B: 20% chance of $500 and 80% chance of getting 0
• Utility of 100 =10 ; Utility of 500 = 30
• EU of A= p(A) X U (A) + P’(A) X U’(A)
• = .9 X 10+ .1 X 0= 9
• EU of B = p(B) X U (B) + P’(B) X U’(B)
• = .2 X 30+ .8 X 0= 6
• EU theory would say that Person 1 should choose A.
 Prospects Theory
Breaking Down
• Developed by: Daniel Kahnemann and Amos
Tversky(1992)
• Association: Associated with Behavioural Finance
• Usage:Decision Making under Risk and Uncertainity
• Stage : Existence of multiple possible outcomes with
different decision weights (instead of probabilities)
which is known as prospects
• Decisions are not made on the basis of probable
expected outcome but on the impact (weights) of
deviation from their current level of wealth
• Prospects Theory offers insights into why people take
non-optimizing decisions.
Prospects Theory (Contd..)
 Key aspects of Prospects Theory
• 1) People are averse to losses as losses looms
larger than gain
• 2) Depending upon the nature of prospects,
people exhibit risk aversion or risk seeking
attitude.
• 3) People value their prospects of gain or
losses in relation to a reference point
Features of Prospect Theory

 Choice under risk and uncertainty

 Reference point and the value function is the
deviation from it
 Look at prospects based on reference point
(e.g purchase price of share)
 Hypothetical value function with S shape
 Generally concave for gains and convex for
losses
 Decision weights rather than probabilities
 The decision weighting function is S-shaped
 Different weights to positive and negative
outcome
 Decisions based on change of wealth not on
total wealth Changes in utility than absolute
utility
 Behavioural
Biases

Psychological/
Cognitive Biases Emotional
Biases
 Cognitive Biases-A systematic error in
thinking process:
• Cognitive errors are defined
as: "...basic statistical, information-processing,
or memory errors that cause the decision to
deviate from the rational decisions of
traditional finance
• There are two types –
• 1)associated with belief perseverance,
2)associated with information processing
 Cognitive Biases:
Belief Perseverance errors
• Cognitive errors associated with belief perseverance relate
to sticking to old beliefs and failing to update probabilities
when presented with new, potentially unsettling,
information
• 1) Conservatism:People emphasize original, pre-existing
information over new data. This can make decision-makers slow to
react to new, critical information and place too much weight on
base rates.
• 2) Confirmation: Seeking out evidence that confirms you beliefs and
ignoring evidence that contradicts them
• 3)Representativeness: judgments based on stereotypes
• 4)Illusion of control: When people believe that they can control or
influence outcomes
• 5)Hindsight Bias: Seeing past events as having been inevitable and
predictable
 Cognitive Biases:
Information Processing errors
• occur when investors irrationally process the information that they
receive.
• Framing Bias:Making skewed decisions based on how a question is
framed
• Anchoring Bias:Sticking too closely to an initial forecast.
• Herd Mentality: investors' tendency to follow and copy what other
investors are doing.
• Negativity bias:the tendency for humans to pay more attention, or
give more weight to negative experiences over neutral or positive
experiences
• Mental accounting Bias:a process about code, categorize, and
evaluate economic outcomes by grouping their assets into any
number of non-fungible (non-interchangeable) mental accounts."
• Availability Bias:Estimating the probability of an outcome based on
how easily it comes to mind
 Emotional Biases-
• Emotional biases "...arise spontaneously as a
result of attitudes and feelings that can cause
decisions to deviate from the rational
decisions of traditional finance.“
• these are when the investor's brain is held
captive by emotions.
Emotional Biases:Irrational thinking by
investors caused by their temporary
emotional state
• Loss Aversion: Tendency to strongly prefer avoiding
losses over acquiring gains.(Losses looms larger than
gains)
• Regret Aversion: avoid admitting errors and realising
losses
• Self Control Bias:failing to act in pursuit of your long-
term financial objectives due to a lack of self-discipline
• Status Quo bias:Doing nothing rather than making
optimal investment decisions
• Over Confidence:Believing that you have superior
knowledge, abilities, and access to information
• Endowment :Valuing assets more when you own them
than when you don't.
 Heuristic Decision Process
• A heuristic is a mental shortcut that allows
people to solve problems and make
judgments quickly and efficiently. These rule-
of-thumb strategies shorten decision-making
time and allow people to function without
constantly stopping to think about their next
course of action. Heuristics are helpful in
many situations, but they can also lead
to cognitive biases.
 Daniel Kahnemann-
Thinking Fast and Slow
 Difference between EUT and PT

• 1)Nature of investor
• 2) Nature of market
• 3) Association
• 4) portfolio design
• 5) Return of portfolio
• 6) Investor’s responds to risk
• 7) Focus of investment
• 8)Responds to gain/losses
• 9) Weights
• 10)