INSTITUTE –University School of Business

DEPARTMENT -Management
Program Name
Course Name: Behavioral Finance and Analytics
Course Code: 22BAA 754
Chandigarh University, Mohali

UNIT-2
DISCOVER . LEARN . EMPOWER

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 Learning Objectives Foundations of Finance

CO Title Level
Number Foundations of Finance –
CO1 To gain an understanding of the concepts Remember Standard and Behavioural
of behavioral finance.
CO2 Analyze psychographic models used in Understand
behavioral finance by retail investors for
investment decisions
CO3 To analyze the effect of different Understand
Behavioural influences on various
investment decisions
CO 4 Differentiating the different investors' Analyze
behaviour in Indian Financial Markets
using segmentation
CO 5 To evaluate investment decisions by Application
retail investors using emerging trends in
financial markets
FINANCIAL BEHAVIORS STEMMING FROM FAMILIARITY

CO3: To analyze the effect of different Behavioural influences on various

investment decisions.

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FINANCIAL BEHAVIORS STEMMING FROM FAMILIARITY

• HOME BIAS
Though preferences are slowly changing in this regard, it continues to
be true that domestic investors hold mostly domestic securities—that
is, American investors hold mostly U.S. securities; Japanese investors
hold mostly Japanese securities; British investors hold mostly U.K.
securities; and so on.
Kenneth French and James Poterba documented this tendency.
Referring to the first numerical column of Table 8.1

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FINANCIAL BEHAVIORS STEMMING FROM
FAMILIARITY
 FINANCIAL BEHAVIORS STEMMING FROM
FAMILIARITY
• Table 8.1, we see displayed the aggregate market values of the six biggest
stock markets in the world. The United States, as of 1989, had 47.8% of
world market capitalization, Japan 26.5%, the U.K. 13.8%, France 4.3%,
Germany 3.8%, and Canada 3.8%.2 Nevertheless, a typical U.S. investor held
93.8% in U.S. stocks; a typical Japanese investor held 98.1% in Japanese
stocks; and a typical U.K. investor held 82.0% in U.K. stocks.
• Thus, domestic investors overweight domestic stocks. This behavior is
called home bias. Bias toward the home country flies in the face of
evidence indicating that diversifying internationally allows investors to
reduce risk without surrendering return.
 FINANCIAL BEHAVIORS STEMMING FROM
FAMILIARITY
• This is particularly true since stock markets in different countries are not
highly correlated. The average pairwise correlation coefficient for the
countries listed in the previous paragraph during 1975–1989 was 0.502,
which attests to the gains from diversification.
• One reason why investors might hold more domestic securities is because
they are optimistic about their markets relative to foreign markets.
• Using an expected utility maximization approach and historical correlations
between markets, French and Poterba estimated what expected returns
would have to be in order to justify the observed asset allocation, and
Table 8.2 reports their results.
Home Bias
• To justify their over-weighted U.S. holdings, American investors
would have to believe that their market would beat the second-best
market (Canada) by 80 basis points; Japanese investors would have
to believe their market would outperform by at least 280 basis
points; and in the United Kingdom, the comparable figure was a
whopping 430 basis points.
• Obviously this set of beliefs is contradictory and implies excessive
optimism—at least on the part of two of the three sets of investors.
The next chapter will focus on excessive optimism in financial
decision-making.
Home Bias
• Another behavioral explanation is along the lines of comfort-seeking
and familiarity.
• People tend to favor that which is familiar. U.S. investors are more
familiar with U.S. stocks and markets, and so they are more
comfortable investing in U.S. securities.
• The same holds equally for foreign investors. As is so often true
where behavioral explanations have been advanced to explain
apparently anomalous behavior, rational explanations are also put
forward.
 Home Bias
• International investment may be less attractive because of institutional
barriers, examples of which are capital movement restrictions, differential
trading costs, and differential tax rates.
• French and Poterba downplay these arguments, however. While at one
time there were significant capital movement restrictions, at the time of
their work, they were not in effect.
• As for differential trading costs, if costs in one country are lower than in
other countries, this is a reason for all investors to favor the low-cost
country, but we do not see this type of behavior.
Home Bias
• Additionally, especially with the international system of dividend
withholding taxes and counterbalancing tax credits, there is little
difference between domestic and foreign tax burdens for most
investors.
HOME BIAS
• Though preferences are slowly changing in this regard, it continues
to be true that domestic investors hold mostly domestic securities—
that is, American investors hold mostly U.S. securities; Japanese
investors hold mostly Japanese securities; British investors hold
mostly U.K. securities; and so on.

• Kenneth French and James Poterba documented this tendency.

HOME BIAS
• Though preferences are slowly changing in this regard, it continues
to be true that domestic investors hold mostly domestic securities—
that is, American investors hold mostly U.S. securities; Japanese
investors hold mostly Japanese securities; British investors hold
mostly U.K. securities; and so on.

• Kenneth French and James Poterba documented this tendency.

HOME BIAS
• Though preferences are slowly changing in this regard, it continues
to be true that domestic investors hold mostly domestic securities—
that is, American investors hold mostly U.S. securities; Japanese
investors hold mostly Japanese securities; British investors hold
mostly U.K. securities; and so on.

• Kenneth French and James Poterba documented this tendency.

HOME BIAS
• Though preferences are slowly changing in this regard, it continues
to be true that domestic investors hold mostly domestic securities—
that is, American investors hold mostly U.S. securities; Japanese
investors hold mostly Japanese securities; British investors hold
mostly U.K. securities; and so on.

• Kenneth French and James Poterba documented this tendency.

 DISTANCE, CULTURE, AND LANGUAGE
• The argument that institutional considerations cause investors to shy away
from foreign investments becomes weak if it can be demonstrated that
people prefer to invest locally, even within their own country. Gur
Huberman reports on a case of such “intra-national” home bias.”
• In 1984, AT&T was forced by the court into a divestiture whereby seven
“Baby Bells” were created. These companies were created along regional
lines.
• An example is BellSouth serving the southeastern United States. If people
like familiarity, then we would expect a disproportionate number of a Baby
Bell’s customers to hold a disproportionate number of shares in the same
Baby Bell.
• Indeed, that is exactly what happened after the divestiture.
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 DISTANCE, CULTURE, AND LANGUAGE
• While we often hear that we should buy locally, from a
diversification standpoint, if anything, you are wise to underweight
(not overweight) local companies.
• If the economy of your region fares poorly, this will be bad both for
the stock market performance of local companies and the
employment prospects of local workers (yourself included).
• If you work and invest locally, technically speaking, your two
income sources are highly correlated. Diversification theory says
you should look for income streams that are weakly correlated.
• For this reason, it would have been better for investors to buy
stock in Baby Bells outside their region. 18
 DISTANCE, CULTURE, AND LANGUAGE
• In a related study, Mark Grinblatt and Matti Keloharju
demonstrate that the preference for familiarity extends to
language and culture.
• In Finland, there are two official languages, Finnish and Swedish.
Annual reports are normally published in Finnish or in both
official languages, but in a few cases reports are only published
in Swedish.
• It turns out that, after controlling for other relevant factors,
Finnish investors prefer companies whose language of
publication is Finnish, and Swedish investors prefer companies
whose language is Swedish—with bilingual companies being
mid-ranked by both groups of investors. 19
 DISTANCE, CULTURE, AND LANGUAGE
• Interestingly, culture matters as well. These authors took
note of whether CEOs were Finnish or Swedish.
Controlling for the language of the company, Finnish
speakers prefer Finnish CEOs, and Swedish speakers
prefer Swedish CEOs.
• The lesson seems clear: familiarity, on all levels, “breeds”
investment.
• Moreover, there is evidence that even institutional
investors may not be immune from this tendency.
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LOCAL INVESTING AND INFORMATIONAL ADVANTAGES

• One reason why investors may favor local markets—

where local is interpreted as either domestic or
close-to-home, but within the same country—is
because they may possess, or may feel that they
possess, informational advantages.
• Gains from being geographically close to a company
may appear in improved monitoring capability and
access to private information.
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 LOCAL INVESTING AND INFORMATIONAL ADVANTAGES
• Joshua Coval and Tobias Moskowitz investigated this issue in the context of
mutual fund managerial performance.
• They first established that mutual fund managers, consistent with familiarity
bias, tend to favor local investments, that is, they tend to buy firms
headquartered within a 100-mile (or 161-kilometer) radius of their head
office.
• Specifically, they conclude that the average manager invests in companies
that are located about 10% closer to her than the average firm she could
have held.
• Further, local equity preference is related to firm size, leverage and output
tradability, with small, levered firms producing goods that are not traded
internationally tending to be the ones where local preference comes through
strongest. 22
 LOCAL INVESTING AND INFORMATIONAL ADVANTAGES
• Consider rational motivations for investing locally. One is hedging
demand. If you consume local goods at local prices, it can make sense
to hedge by investing locally.
• If locally produced goods are not traded outside the local region, then
it is reasonable to talk about local prices. Take haircuts, which are as
non-tradable as one gets.
• If you buy the stock of a local haircutting company, your future haircut
consumption, which must be local, is well hedged.
• The finding that local equity preference is more pronounced among
companies whose goods are not traded internationally is consistent
with hedging demand.
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 LOCAL INVESTING AND INFORMATIONAL ADVANTAGES

• Size and leverage, on the other hand, suggest an information

differential explanation, as smaller, levered firms are likely to
be ones for which local informational advantage may be
stronger.
• To test this, Coval and Moskowitz investigate whether local
preference can generate a boost to performance.
• As has been discussed previously, most studies indicate that
the average actively managed mutual fund has been unable to
consistently outperform its benchmark on a risk-adjusted basis.
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 LOCAL INVESTING AND INFORMATIONAL ADVANTAGES
• Notably though, Coval and Moskowitz demonstrate a significant payoff to local
investing. Fund managers on average earn 2.67% per year more on local
investments, while local stocks avoided by managers underperform by 3% per year.
• Moreover, they find that those better able to select local stocks tend to concentrate
their holdings more locally. Are retail investors also able to exploit this?
• The evidence points in this direction as stocks with high levels of local ownership
tend to outperform, and this effect lasts for several months, suggesting those with
access to such data could earn excess returns.
• In other research, there is evidence that retail investors take advantage of the
opportunity.
• Reminiscent of the money manager finding, based on a dataset of retail investors,
local investments outperform remote investments by 3.2% per year.

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 INVESTING IN YOUR EMPLOYER OR BRANDS THAT YOU KNOW
• There is also abundant evidence that investors overweight the
stocks of companies whose brands are familiar or that they
work for.
• As for the first, Laura Frieder and Avanidhar Subrahmanyam
looked at survey data on perceived brand quality and brand
familiarity (recognition) and asked whether these attributes
impacted investor preferences.
• To answer this question, they correlated institutional holdings
with these factors. Note that high institutional holding in a
stock implies low retail holding in that same stock.
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 INVESTING IN YOUR EMPLOYER OR BRANDS THAT YOU KNOW

• These researchers found that institutional holdings are

significantly and negatively related to brand recognition, but
no discernible impact was present for brand quality.
• The former implies that retail investors have a higher demand
for firms with brand recognition, which is consistent with
comfort seeking and familiarity.
• Still, Frieder and Subrahmanyam argue that recognizable
brands are associated with companies with more readily
accessible information for average investors.
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 INVESTING IN YOUR EMPLOYER OR BRANDS THAT YOU KNOW
• They provide a model that shows that investors will, ceteris paribus, demand
more of a stock when they have more precise information about the stock.
• Therefore, in this context as in others, a natural informational advantage may
stem from familiarity.

• As for overweighting companies that one works for, while the same sort of
familiarity versus informational advantage debate is possible, the extent to
which some investors invest in these companies seems to transcend an
informational explanation.
• Many “employee-investors” put a very high percentage of their investible
wealth in their employer’s stock, thus foregoing a significant amount of
possible diversification
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 References
• WebLinks
• https://www.kitces.com/blog/behavioral-finance-heuristics-bias-positive-outcomes-improve-financi
al-decision-making/
• https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3208612
• http://arno.uvt.nl/show.cgi?fid=129741
• https://quizlet.com/129621639/fin09106-ch-8-implications-of-heuristics-and-biases-for-financial-d
ecision-making-flash-cards/

• References
• Ackert, L. and Deaves, R. (2115). Behavioral Finance. Ist Ed. Mason, OH: South-Western Cengage
Learning. ISBN: 978-0-324-66117-0.
• Pompian, M. 2106. Behavioral Finance and Wealth Management.Ist Ed. Wiley: New Jersey. ISBN: 0-
471-74517-0.

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 References
• Video Links
• https://www.essentia-analytics.com/common-behavioral-biases/
• https://www.coursera.org/lecture/biases-portfolio-selection/what-are-heuristics-driven-biases-QhE
4x
• https://www.youtube.com/watch?v=ReFqFPJHLhA
• https://www.coursera.org/lecture/duke-behavioral-finance/the-availability-heuristic-AwddY
•

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