Behavioural Finance-An explanation to

Irrational Investment Behaviour

1.
 Heuristic Driven Biases
1. Representativeness
Refers to the tendency to form judgments based on
stereotypes
E.g.:- students performance(school)
Examples
 Investors assume that good companies are good stocks
 Investors may become overly optimistic about past
winners and overly pessimistic about past losers
 Investors may believe that a healthy growth of earnings in
the past may be representative of high growth rate in
future.
 Heuristic Driven Biases

2. Overconfidence
Overconfidence stems partly from the illusion of knowledge-the human
mind is perhaps designed to extract as much information as possible
from what is available, but may not be aware that the available
information is not adequate to develop an accurate forecast in
uncertain situations

Overconfidence is the result of the illusion of control-people tend to

believe that they have influence over future outcome in an uncertain
environment

Overconfidence manifests itself in excessive trading in financial

markets.
 Heuristic Driven Biases

3. Anchoring
After forming an opinion ,people are often unwilling to change it,
even though they receive new information that is relevant.

E.g.-suppose that the investors have formed an opinion that company

A has an above average long tem earnings prospect. Suddenly A
reports much lower earnings than expected. thanks to anchoring,
investors will persist in the believe that the company is above
average and will not react sufficiently to the bad news.
 Heuristic Driven Biases

4. Familiarity
People are comfortable to things that are familiar to
them. The human brain often uses the familiarity
shortcut in choosing investments.
Familiarity breeds investment. That is why people tend
to invest more in the stocks of their employer
company, local companies, and domestic companies.
 Heuristic Driven Biases
5. Aversion to ambiguity
People are fearful of ambiguous situations where they
feel that they have little information about the
possible outcomes.

Investors are wary of stocks that they feel they don’t

understand

Investors have a preference for the familiar

 Heuristic Driven Biases

6.Innumeracy
People have difficulty with numbers

Trouble with numbers is reflected in the following

 People confuse between nominal changes (greater or lesser numbers of actual

rupee )and real changes(greater or lesser purchasing power)

 People have difficulty in figuring out the true probabilities

 People tend to pay more attention to big numbers and give less weight to small

figures

 People estimate the likelihood of an event on the basis of how bright the past

examples are and not on the basis of how frequently the event has actually

occurred
 2. Frame Dependence
Meaning

Behaviour is frame dependent. This means that the form used to

describe a problem has a bearing on decision making. Frame
dependence stems from a mix of cognitive and emotional factors

The cognitive aspects relate to how people organise information

mentally, in particular how they code outcomes into gains and
losses

The emotional aspects pertain to how people feel as they register

information
2.1
 2.2 Mental accounting
 Developed by Richard Thaler
 People separate their money into various mental accounts
and treat a rupee in one account differently from a rupee in
another because each account has a different significance
to them.
 Division of current and future asset into different groups
are differently treated.
 2.3 Narrow Framing
 Investors tend to look at each investment separately rather than the portfolio in

its reality

 They are more focused on price changes in individual stocks and less concerned

about the behaviour of the overall portfolio

 Lead people to overestimate risk

 The more narrowly the investor frames the more often an investor sees losses

 While several individual securities in a portfolio may have negative returns, the

portfolio as a whole is likely to have a positive return

 Although the stock often produces negative returns in the short run, it rarely

delivers negative returns in the long run

 2.4. The Shadow of the Past
After experiencing a gain ,people are willing to take more risk. After
winning money in a gamble ,amateur gamblers somehow don’t fully
consider the winning as their own and are hence are tempted to risk it
in further gambles. Gamblers refers to this as the house-money effect
After incurring a loss, people are less inclined to take risk. This is
sometimes referred to as the snake-bite effect.
Loser’s do not always shun risk. People often jump at the chance to
recover their losses. This is referred to as trying-to-break-even
effect.
 m
mO
2.5 Behavioural Portfoliose pt
r
i
 Investors to hold their portfolio in a pyramid of c
o
i n
assets based on the goals like safety, income and R Sa s
l
growth e
t
 The salient features of the pyramid of behavioral s P
portfolio are vas follows i Bor
 Each layer in the pyramid represents assets meant to
c
do p
o

e ke
nns rt
meet a particular goal.

Investors have separate mental accounts for each

td y


investment goal and they are willing to assume

different levels of risk for each goal Cias
 The asset allocation on an investor’s portfolio is al
determined by the amount of money assigned to
s
each asset class by the mental account. h
 3. Emotional and social influences
3.1 Emotional Time Line
Emotions have a bearing on risk tolerance, and risk tolerance influence
portfolio selection.

Investors experience a variety of emotions

1. Consideration of alternatives

2. Decide how much risk to take

3. Watch their decisions play-out

4. Assess whether initial strategy needs modification

5. Learn how far they have succeeded in achieving their financial

objectives
 3.2. Heard instincts and Overreaction

 Natural desire to be part of a group

 People tend to group together
 Moving with the group magnifies the psychological
biases
 Induces one to decide on the feel of the group rather
than on rigorous independent analysis
 4. Market Inefficiencies

 Investors trade on the basis of rumors, sentiment or

noise not on the fundamentals
 It consists of

4.1 Noise Trading

4.2 Limits to arbitrage
4.3 Price behaviour
 4.1 Noise Trading
Many investors trade on noise, and not on fundamentals
As long as these investors trade randomly, their trades cancel out and
likely to have no perceptible impact on demand.

Good portion of noise traders employ similar strategies ,as they suffer
from similar judgmental biases while processing information

e.g. They tend to be overconfident and hence assume more risk

They tend to extrapolate past time series and hence chase trends

They follow market gurus and act in the similar fashion

 4.2 Limits to arbitrage

 Arbitragers support the fundamentals and free from

sentiments.
 Try to purchase the undervalued stock which tends
to be very risky because the market may fall
further and inflict losses.
 The fear of such loss may restrain arbitrageurs
from taking large enough long positions that will
push price to fully confirm to fundamentals.
 4.3 Price Behavior
 Investor sentiments influence the price of stocks

 Price often vary more than what is warranted by changes in

fundamentals.

 Arbitrageurs may also contribute to price volatility to take the

advantage of mood swings of noise traders.

 The chance of purchasing the stocks when prices are decreasing

and selling the stocks when the prices are increasing

 Strategies for overcoming
psychological biases
 Understand the biases
 Focus on the big picture
 Diversify
 Follow a set of quantitative investment
criteria
 Control investment environment
 Strive to earn market returns
 Review biases periodically