Topic 4B

Behavioural Finance

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“The investor’s chief problem,

and even his worst enemy, is
likely to be himself.”

-Benjamin Graham
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 We know that when you’re dealing with the EMH, there are several
anomalies that exist

 This lead to the idea that markets consist of human beings so it is

logical that explanations of market behaviour include some aspect of
human and social psychology.

 Thus, behavioural finance is a branch of financial theory that

examines human behaviour and investment psychology on
investment decisions and market prices.
Traditional vs Behavioral finance 4
Traditional Financial Theory

Traditional finance includes the following beliefs:

 Both the market and investors are perfectly rational

 Investors truly care about utilitarian characteristics

 Investors have perfect self-control

 They are not confused by cognitive errors or information processing errors 

Behavioural Finance Theory

Traits of behavioural finance are:

 Investors are treated as “normal” not “rational”

 They actually have limits to their self-control

 Investors are influenced by their own biases

 Investors make cognitive errors that can lead to wrong decisions

Building blocks that make up behavioral finance 5
#1 Self-Deception

 The concept of self-deception is a limit to the way

we learn. When we mistakenly think we know more
than we actually do, we tend to miss information
that we need to make an informed decision.

#2 Heuristic Simplification

 Heuristic simplification refers to information-

processing errors.

#3 Emotion

 Basically, emotion in behavioral finance refers to

our making decisions based on our current
emotional state. Our current mood may take our
decision making off track from rational thinking.

#4 Social Influence

 how our decision making is influenced by others.

Beh Finance biases: 6

1. Overconfidence and illusion of control

2. Self Attribution Bias

3. Hindsight Bias

4. Confirmation Bias

5. The Narrative Fallacy

6. Representative Bias

7. Framing Bias

8. Anchoring Bias

9. Loss Aversion

10. Herding Mentality

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Assumptions of BF
 Errors made in processing information by individual
investors in processing information must be correlated
across investors so that they are not averaged out
 Investors exhibit behavioural biases which cause them to
over- and under-react
 Limited arbitrage: The existence of rational investors
should not be sufficient to make markets efficient
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Concepts in Behavioural
Finance

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Heuristics
 Heuristics refer to rules of thumb that individuals use to
make decisions in complex, uncertain environments.
 When our heuristics fail to produce a correct judgement, it
can sometimes result in a cognitive bias, which refers to a
common tendency to process information by filtering it
through one’s own likes, dislikes and experiences.
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• Individuals process using “two minds”  intuitive and

reflective.

Muller-Lyer
Illusion
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Representative Heuristics/
Representativeness Bias
 The tendency of individuals to categorize a situation based on a
pattern of previous beliefs about the scenario.
 E.g. Gamblers Fallacy  a person’s belief that the probability of
an event occurring changes based on previous attempts, when in
reality, the probability remains the same
 Hot hand fallacy
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Hot Hand fallacy
 Suppose we look at the recent goals scored by Messi and Ronaldo
 Assume both of these players make half of their shots.
 Messi: has just scored two goals in a row
 Ronaldo: has just missed two goals in a row

 Researchers have found that if they ask soccer fans which player
has the better chance of making their next shot:
 91 out of 100 will say Messi.
 They say this because they think Messi has a “hot-hand.” (or in this
case a “hot foot”

 But, researchers have found that the “hot hand” is an illusion.

 Players do not deviate much from their long-run shooting averages.
 However, fans, players, announcers, and coaches think that they do.
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Herd Behaviour

 The tendency of people

to mimic the actions of a
larger group, whether its
rational or irrational.
 Reasons? Social
conformity, belief that a
large group of people
can’t be wrong.
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Example of herd behavior used by

Robert Shiller
 Imagine two restaurants open, next to each other. The first hungry
customer doesn’t know which restaurant is better, so he flips a coin
and hopes for the best. A little bit later, another customer arrives. He
also doesn’t know which restaurant is better, but he assumes that the
restaurant with at least one customer must be better. When the third
customer shows up, he sees two people in one restaurant and none in
the other, so he also goes to the popular place. The cycle continues in
this manner, and most customers end up choosing the popular
restaurant, even though the other restaurant might serve better food.
We clearly find comfort in numbers, especially when feeling anxious.
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Memory Bias
 People give too much weight to recent experience compared to
prior beliefs when making forecasts, in which case they tend to
make forecasts which are too extreme.
 This gives a proposed explanation to why the PE effect occurs.
(People expect the earnings of a firm to be too high, because of
recent performance which was good, but these estimates are too
high, which means there is an initial high PE ratio, but poor
subsequent performance because investors realize their error)
Overconfidence & Optimism 17

/Wishful thinking
 Overconfidence refers to the tendency of individuals to
overestimate their knowledge, underestimate risk, and
exaggerate their ability to control events (belief that individual is
consistently able to beat the market).
 Over optimism is where individuals believe outcomes of events
will be better for them than for others. The implication of this is
that investors take on bad investments as they fail to see they have
inadequate information, and they trade more often than would be
safe to do so (essentially = poor investment decisions). This bias
can get worse (related to overconfidence).
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Conservatism bias
 Investors are too slow (conservative) in updating their
beliefs in response to any new information.
 This results in under-reaction, where the process of stock
prices incorporating new information does not happen
immediately (as suggested by the EMH), but rather occurs
gradually over time.
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Self attribution bias

 There are 2 kinds: self-enhancing bias and self-protecting bias

 Self-enhancing bias  the tendency of people to attribute success

solely to themselves, without acknowledging any external forces
 Self-protecting bias  the tendency of individuals to deny any
responsibility for failure – they therefore blame unsuccessful
outcomes on bad luck.
 As a result, they overreact to public information which confirms an
investor’s private information, and under-react to public signals
that go against the investor’s private information.
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Availability Bias
 The tendency of individual to overestimate the likelihood
of an infrequent event occurring in the future if that event
occurred in the recent past.
 The availability bias is closely linked to the overreaction
hypothesis as it states that the decisions made by investors
are dependent on the latest available info. This bias can
make investors’ reactions to the market signals too
extreme causing under/overreaction to change in market
conditions.
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Confirmation Bias
 Investors may be more likely to seek out information that supports
his/her original idea about an investment, rather than look for
information that contradicts it.
 Eg. You hear about a “hot stock” from a friend and upon
investigating, find all the good things about that stock, but in the
process ignore the red flags.
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Hindsight bias (‘I knew it all along

‘ effect)
 Tends to occur in situations where a person believes (after
the fact) that the onset of some past event was
predictable and completely obvious, whereas in fact, the
event could not have been reasonably predicted.
 Eg. Fishoff – “creeping determinism”.

 This bias can lead to overconfidence as investors often

think that they predicted past events and can therefore
predict future events, which often leads to poor
investment decisions.
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Cognitive Dissonance
 This is the mental conflict that individuals experience when they
are faced with evidence that their beliefs or assumptions are wrong.
 As a result, there is a tendency for people to take actions which will
reduce the cognitive dissonance that would not normally be
considered as rational, such as avoiding new information, or
developing distorted arguments in order to maintain their beliefs.
 This theory is considered one of the most influential and extensively
studied theories in social psychology.
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Example:
 You buy a share worth R50. A month later, the stock price
falls to R45 due to bad earnings reports. The overall
prospects for the company doesn’t look good, and most
analysts think the stock price may drop much further.
Despite this news, you decide to hold on to the stock with
the belief that what goes down usually comes back up 
disposition effect (holding losers too long and selling
winners early)
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Anchoring
 This heuristic refers to the way individual assess probabilities in an
intuitive manner. Individuals start from a reference point (the
anchor) and from there makes adjustments to reach their own
estimate.
 e.g. Many investors say that you should not sell a poorly performing
stock until it rebounds to its original price
 The anchor point may be completely relevant or based on correct
info -possibly not selling at discount, could be a change in
fundamentals.
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 The power of random anchors has been demonstrated in
some unsettling ways. German judges with an average of
more than fifteen years of experience on the bench first read
a description of a woman who had been caught shoplifting,
then rolled a pair of dice that were loaded so every roll
resulted in either a 3 or a 9. As soon as the dice came to a
stop, the judges were asked whether they would sentence
the woman to a term in prison greater or lesser, in months,
than the number showing on the dice. Finally, the judges
were instructed to specify the exact prison sentence they
would give to the shoplifter. On average, those who had
rolled a 9 said they would sentence her to 8 months; those
who rolled a 3 said they would sentence her to 5 months; the
anchoring effect was 50%.

 (Kahneman, Daniel. 2011.Thinking, Fast and Slow. pp. 125-

126.)
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Prospect Theory

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 Developed as an alternative to Expected Utility Theory

 Expected Utility Theory – The Efficient Market model

implicitly assumes that investors are rational and make all
their decisions in the attempt to maximise their expected
utility. (EU is calc by taking the weighted avg of all possible
outcomes under certain circumstances)
 For example, if an individual had to choose between
getting R100 if a coin toss lands on heads (and nothing if it
lands on tails), or a certain payment of R49, he will choose
to toss the coin. This is because, the expected utility from
the coin toss = R100 x 50% = R50, which is greater than the
R49 with certainty.
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Prospect Theory

There are three major cognitive errors discovered by Daniel

Kahneman and Amos Tversky (who developed prospect theory).
 Framing

 Mental accounting

 The House money effect

Framing 30

 If a problem is presented in two different (but equivalent)

ways, investors make inconsistent decisions.
 When Kahneman and Amos Tversky framed questions in terms
of gains and losses, they immediately realized that people hated
losses. In fact, our dislike of losses was largely responsible for
our dislike of risk in general.

 Because we felt the disadvantages of risky decisions (losses)

more acutely than the advantages (gains), most risks struck us as
bad ideas. This also made options that could be forecast with
certainty seem especially alluring, since they were risk-free.

 As Kahneman and Tversky put it, “In human decision making,

losses loom larger than gains.” They called this phenomenon
“loss aversion”
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Consider this example: The following scenario was
posed to physicians:
 The U.S. is preparing for the outbreak of an
unusual Asian disease, which is expected to kill 600
people. Two alternative programs to combat the
disease have been proposed. Assume that the
exact scientific estimates of the consequences of 72 percent chose option A,
the programs are as follows: the safe-and-sure strategy,
and only 28 percent chose
 If program A is adopted, 200 people will be saved.
program B, the risky
strategy.
 If program B is adopted, there is a one-third
probability that 600 people will be saved and a
two-thirds probability that no people will be saved.
Which of the two programs would you favour?
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Now consider an alternative scenario:

 The U.S. is preparing for the outbreak of an
unusual Asian disease, which is expected to kill
600 people. Two alternative programs to
combat the disease have been proposed.
Assume that the exact scientific estimates of the Only 22 percent voted
consequences of the programs are as follows: for option C, while 78
percent of them opted
 If program C is adopted, 400 people will die. for option D
 If program D is adopted, there is a one-third
probability that nobody will die and a two-
thirds probability that 600 people will die.
Which of the two programs would you favour?
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Conventional
utility function
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Mental accounting
 Mental Accounting is a specific form of framing, which was
first noticed by the famed economist Richard Thaler. Under
this phenomenon, people tend to segregate certain
decisions into different mental accounts. For example:

 Imagine you have decided to go and see a movie and have

paid the admission price of R10 for your ticket. As soon as When Thaler
you enter the theatre, you find out that you have lost the conducted this
ticket, and it cannot be recovered in any way. Would you survey, he found
pay R10 for another ticket? that only 46% of
people would buy
another ticket.
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He then asked the following question:
 Imagine that you have decided to see a movie, for which
one ticket costs R10. Just as you enter the theatre, you
discover that you have lost a R10 note. Would you pay R10
for a ticket to the movie?
 In this instance, even though the value of the loss is the
same in both scenarios, 88% of people said they would still
buy the movie ticket. Why such a drastic difference in
answers?

Accourding to Thaler, going to a movie is usually viewed as a transaction in which

the cost of a ticket is exchanged for the experience of seeing the movie. Therefore,
buying a second ticket made the movie seem to expensive since it now “costs” R20.
However, the loss of the cash is not posted to the mental account of the movie, so
many people do not mind buying the movie ticket.
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 Another example: An experiment was conducted where

M&Ms were placed in a hotel lobby with a small scoop.
The next day, they placed the same amount of M&Ms, but
this time with a bigger scoop. On the second day, on
average people took 66% more M&Ms, even though they
could have gotten the same amount on the first day by
simply scooping a few times. This explains why larger
serving sizes usually make people eat more.
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The House Money Effect

 This is a form of mental accounting

 This occurs when individuals are more likely to take risk

when prior outcomes have been positive, and they are
therefore investing with their profits/gains
 Term coined from the gambling phrase “playing with the
house’s money”
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Limits to arbitrage

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The behavioural biases analyzed here would

imply that rational investors could fully profit
from the mistakes of behavioural investors,
because as soon as prices go out of alignment,
rational investors would rapidly react in order to
restore equilibrium. However, behavioural
advocates argue that this does not happen in
practice because of the following factors:
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Fundamental risk
 If a share is underpriced, whilst buying it Should represent a profit
opportunity, in reality the underpricing could get worse before it
gets better.
 Therefore whilst prices should eventually converge to its intrinsic
value, the period of time taken for this to happen is unknown, and it
could only happen after the trader’s investment horizon.
 Therefore, the risk incurred in exploiting the profit opportunity,
may prevent traders from acting on mispricing.
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Implementation costs
 These can include transaction costs and short-sale
constraints (could be financial or legal/regulatory – include
fees, volume restraints and legal restraints). Also,
commission, Bid/Ask Spread and the costs of identifying
mispricing.
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Model risk
 One may always worry that an apparent profit opportunity is due to
using a faulty model to value the security.
 Therefore when an asset is mispriced the strategies to correct this
mispricing can be both risky and costly making them unattractive
investments even if the mispricing suggests a profitable arbitrage
opportunity. This is in fact the key argument for mispricing existing –
that they can be too risky or costly to correct.
Differences between Conventional finance and 43
Behavioural Finance
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Criticisms of Behavioural finance

 Behavioral finance tries to explain anomalies, but do not
give guidance of how to exploit these irrationalities
 Behavioral finance explains each anomaly by some
combination of irrationalities from the list of behavioral
biases. There is not a unified behavioral theory to explain a
range of anomalies
 It is possible to have contradiction between different
theories, e.g., overreaction (from representativeness bias)
vs. underreaction (form conservatism bias)