Name :- Panaparambil Abhinav Anirudhan

Course:- MBA Finance

Enrollment no:- A001110721028
Roll no :- A54
Subject :- Behouvioral Finance

1. Discuss the role and importance of Psychology in behavioural

Finance.
Ans) Behavioural finance is an area of study focused on how psychological
influences can affect market outcomes. Behavioural finance can be analyzed
to understand different outcomes across a variety of sectors and industries.
One of the key aspects of behavioural finance studies is the influence of
psychological biases. Some common behavioural financial aspects include
loss aversion, consensus bias, and familiarity tendencies. The efficient
market theory which states all equities are priced fairly based on all available
public information is often debunked for not incorporating irrational
emotional behaviour. Behavioral finance can be analyzed from a variety of
perspectives. Stock market returns are one area of finance where
psychological behaviors are often assumed to influence market outcomes
and returns but there are also many different angles for observation. The
purpose of the classification of behavioral finance is to help understand why
people make certain financial choices and how those choices can affect
markets. Within behavioral finance, it is assumed that financial participants
are not perfectly rational and self-controlled but rather psychologically
influential with somewhat normal and self-controlling tendencies. Financial
decision-making often relies on the investor's mental and physical health. As
an investor's overall health improves or worsens, their mental state often
changes. This impacts their decision-making and rationality towards all real-
world problems, including those specific to finance.
One of the key aspects of behavioral finance studies is the influence of
biases. Biases can occur for a variety of reasons. Biases can usually be
classified into one of five key concepts. Understanding and classifying
different types of behavioral finance biases can be very important when
 narrowing in on the study or analysis of industry or sector outcomes and
results.
2. Discuss Limits to arbitrage with an example
Ans) Arbitrage happens when a rational trader spots a price difference in an
asset in two different markets and invests accordingly. The efficient market
hypothesis states that this intervention will help correct and balance the markets.
However, if these rational traders work for asset management firms and invest
other people's money, their actions will be heavily scrutinised. If they engage in
arbitrage and the prices remain unbalanced for a while, the clients may be
unhappy and the trader may have to unwind the position at a loss. Therefore
there is a limit to the arbitrage that the trader can engage in. In 1907, two
completely independent companies: Royal Dutch and Shell Transport, agreed to
merge their interests on a 60:40 basis, while remaining separate companies.
Share of Royal Dutch are a claim to 60% of the total cash flow of the two
companies, while Shell is a claim to the remaining 40%. Since 60% of the new
company is comprised by Royal Dutch and 40% by Shell Transport, if prices
equal fundamental value, the market value of Royal Dutch equity should always
be 1.5 times the market value of Shell equity. However it is not. In the past,
Royal Dutch has traded 35% underpriced relative to parity, and sometimes 15%
overpriced.
This mispricing is a clear evidence of limits to arbitrage. In this case the shares
are good substitutes for each other so fundamental risk is nearly perfectly
hedged. In addition there are no major implementation costs because buying and
shorting shares of either company is relatively easy. Professors Thaler and
Barberis argue that the one risk that remains is noise trader risk. Whatever
investor sentiment is causing one share to be undervalued relative to the other
could also cause that share to become even more undervalued in the short term.
In fact, if you bought Royal Dutch shares in March 1983 which traded at a price
10% undervalued ,you would have seen the stock drop even further in the
following six months. This shows that arbitrage in this case was limited because
clearly prices were not right, but on the other hand there were no profits to be
made for arbitrageurs.

3. Discuss various strategies for overcoming Psychological Biases

and its effect on stock market
Ans)
 1. Check your stocks only once every month
2. Trade only once every month and preferably on the same day of the month
3. Review your portfolio once or twice a year
Strive to Earn Market Returns: Seek to earn returns in line with what the
market offers. If you strive to out perform the market, you are likely to succumb
to psychological biases. Review Your Biases Periodically: Once in a year
review your psychological biases. This will throw up useful pointers to contain
such biases in future.
The central assumption of the traditional finance model is that people are
rational. The behavioural finance model, however, argues that people often
suffer from cognitive and emotional biases and act in a seemingly irrational
manner.
The important heuristic driven biases and cognitive errors that impair
judgment are: representativeness, over confidence, anchoring aversion to
ambiguity and innumeracy. Representatives refers to the tendency to form
judgments based on stereotypes. People tend to be over confident and hence
over estimate the accuracy of their forecasts. Thanks to anchoring, also
called conservatism people are often unwilling to change an opinion even
though they receive new information that is relevant. People are fearful of
ambiguous situations where they feel that they have little information about
the possible outcomes. People have difficulty with numbers. Proponents of
traditional finance believe that framing is transparent implying that investors
can see through all the different ways cash flows might be described. In
reality behaviour tends to be frame de-pendent. This means that the form
used to describe problem has a bearing on decision making. Frame
dependence stems from a mix of cognitive and emotional factors.

4. Explain behavioural biases of Institutional Investors with

examples
Ans) Mental accounting refers to the concept where people treat money
differently depending on where it came from and what we think it should be
used for. The idea is that we separate our money into "mental accounts" for
different uses, which influences our spending decisions. We guard some
money cautiously when we mentally categorize it for a house, but spend it
liberally when it's "fun money". How to overcome it: Create a budget to
 guide your financial decisions and better determine when to save versus
spend money. And create a plan for how to spend windfall gains, like an
inheritance or work bonus, ahead of time.
Loss aversion is a bias toward avoiding losses over seeking gains. Loss
aversion causes us to avoid small risks even when they're probably worth it.
It's why people save rather than invest, even though inflation will erode the
value of their savings — and many investments, when held for long enough,
pay off. How to overcome it: Don't leave it up to emotion. Create an
investing strategy and stick to it. Make a mental effort to adopt some risk by
considering assets that typically perform well, such as an index fund that
follows the S&P 500.
Overconfidence bias is the tendency to see ourselves as better than we are.
It's common in investing. A 2020 review published in the International
Journal of Management found that overconfident individual investors
generally do not manage and control risk properly. How to overcome it: If
you're a beginning investor, consult a professional and get a gut check on
your investing strategy to solicit alternative perspectives. And consider
sticking to passive investing rather than trying to time the markets. After
all, active traders tend to do worse than those who buy and hold.

Anchoring is a phenomenon where someone values an initial piece of

information too much to make subsequent judgments. In investing, this can
influence decision-making regarding a security, such as when to sell or buy an
investment. Since many investment decisions require multiple complex
judgments, they're vulnerable to anchoring bias. For example, a person may
hold on to a stock longer than they should because they've "anchored" on the
higher price than they bought it at. The buying price biases their judgments
about the stock's true value. How to overcome it: Take time to do research and
make a decision. A comprehensive assessment of an asset's price helps reduce
anchoring bias. Finally, be open to new information — even if it doesn't
necessarily align with what you've initially learned.

Herd behaviour happens when investors follow others rather than making their
own decisions based on financial data. For example, if all your friends are
investing in penny stocks, you might start too even though it's risky. How to
overcome it: Step back and look at investments carefully: Dwelve into a
company's fundamentals and see if it actually looks like a solid investment. And
be skeptical of hot stocks promoted on internet forums.

5. Discuss Behavioural Corporate Finance and its impact on

financial decision making.
Ans)
Behavioural Corporate Finance provides new and testable explanations for
long-standing corporate-finance puzzles by applying insights from
psychology to the behaviour of investors, managers, and third parties (e. g.,
analysts or bankers). As an investor's overall health improves or worsens,
their mental state often changes. This impacts their decision-making and
rationality towards all real-world problems, including those specific to
finance.
One of the key aspects of behavioural finance studies is the influence of
biases. Biases can occur for a variety of reasons. Biases can usually be
classified into one of five key concepts. Understanding and classifying
different types of behavioural finance biases can be very important when
narrowing in on the study or analysis of industry or sector outcomes and
results.
Behavioural finance typically encompasses five main concepts:
Mental accounting: Mental accounting refers to the propensity for people to
allocate money for specific purposes.
Herd behaviour: Herd behaviour states that people tend to mimic the
financial behaviours of the majority of the herd. Herding is notorious in the
stock market as the cause behind dramatic rallies and sell-offs.
Emotional gap: The emotional gap refers to decision-making based on
extreme emotions or emotional strains such as anxiety, anger, fear, or
excitement. Oftentimes, emotions are a key reason why people do not make
rational choices.
 Anchoring: Anchoring refers to attaching a spending level to a certain
reference. Examples may include spending consistently based on a budget
level or rationalizing spending based on different satisfaction utilities.
Self-attribution: Self-attribution refers to a tendency to make choices based
on overconfidence in one's own knowledge or skill. Self-attribution usually
stems from an intrinsic knack in a particular area. Within this category,
individuals tend to rank their knowledge higher than others, even when it
objectively falls short.

6. Explain the following with examples

7. (a) Mental Accounting
Mental accounting refers to the different values a person places on the same
amount of money, based on subjective criteria, often with detrimental
results. Mental accounting is a concept in the field of behavioural
economics. Developed by economist Richard H. Thaler, it contends that
individuals classify funds differently and therefore are prone to irrational
decision-making in their spending and investment behaviour.

(b) Equity Premium puzzle

The equity premium puzzle (EPP) refers to the excessively high historical
outperformance of stocks over Treasury bills, which is difficult to explain. The
equity risk premium, which is usually defined as equity returns minus the return
of Treasury bills, is estimated to be between 5% and 8% in the United States.
The premium is supposed to reflect the relative risk of stocks compared to "risk-
free" government securities. However, the puzzle arises because this
unexpectedly large percentage implies an unreasonably high level of risk
aversion among investors

(c) Prospect Theory

The prospect theory says that investors value gains and losses differently,
placing more weight on perceived gains versus perceived losses. An investor
presented with a choice, both equal, will choose the one presented in terms of
potential gains. Prospect theory is also known as the loss-aversion theory.

(d) Framing
In simple words, framing bias means that the investors are more responsive to
the context in which information is presented as opposed to the content of the
information. This can be seen from the fact that investors react to the same
information differently if it is presented in a different context. Framing bias also
has some subtypes. For instance, there is a phenomenon known as "narrow
framing." In this phenomenon, the investors focus only on a few aspects of an
investment to the exclusion of everything else. For instance, some investors
might be too focused on the price-earnings ratio of a stock and may not pay
attention to all other data, which is obviously very important in the valuation of
a stock.

(e) Allais Paradox and Ellsberg Paradox

The Allais Paradox refers to a classic hypothetical choice problem in
behavioural economics that exposes human irrationality. Daniel
Kahneman offered a simplified version of the puzzle in his seminal book,
Thinking, Fast and Slow. This refers to the tendency to choose to deal
with risky scenarios where people know the probability of the various
possible outcomes as against alternative scenarios where they do not
know the probable outcomes. This occurs even when the chances of
winning are higher in the scenario where the probabilities are unknown.
This is used to explain why people try to avoid situations that involve any
degree of uncertainty regarding the outcome and instead prefer stability.
It is named after American whistle-blower Daniel Ellsberg who proposed
it in his paper “Risk, ambiguity and the savage axioms”.

(f) Expected Utility Theory

Expected utility refers to the utility of an entity or aggregate economy
over a future period of time, given unknowable circumstances. Expected
utility theory is used as a tool for analyzing situations in which
individuals must make a decision without knowing the outcomes that may
result from that decision
The expected utility theory was first posited by Daniel Bernoulli who
used it to solve the St. Petersburg Paradox. Expected utility is also used to
evaluate situations without immediate payback, such as purchasing
insurance.

8. Discuss Information Processing – Rational, Intuitive and Dual

processing, Bayesian information.
Ans)
Rational decision making leverages objective data, logic, and analysis
instead of subjectivity and intuition to help solve a problem or achieve a
goal. It’s a step-by-step model that helps you identify a problem, pick a
solution between multiple alternatives, and find an answer. Intuitive
processing is based on tacit knowledge that has been acquired without
attention during a person's life and is thus fueled by it (e.g., Bowers et al.,
1990). In combination these aspects result in the subjective experience of
“knowing without knowing why” as Claxton. Dual processing theory of
human cognition postulates that reasoning and decision-making can be
described as a function of both an intuitive, experiential, affective system
(system I) and/or an analytical, deliberative (system II) processing
system. The Bayesian Information Criterion, or BIC for short, is a method
for scoring and selecting a model. It is named for the field of study from
which it was derived: Bayesian probability and inference. Like AIC, it is
appropriate for models fit under the maximum likelihood estimation
framework.